Is Active Management a Farce?

Terry Savage Author, The Savage Truth on Money

Yet another study shows that there is essentially no difference between actively managed mutual funds and index funds, especially once you consider the higher fees, writes MoneyShow's Terry Savage.

Are you still trying to outguess the stock market? That’s a futile proposition for even most professional money managers.

A new study by noted investment advisor Harold Evensky proves the point. An analysis of 20 years of mutual fund performance results—during both up and down markets, and good economic times and recessions—shows that there is no decided advantage in using actively managed mutual funds, especially when costs are taken into consideration.

The study itself was done with Professor Shaun Pfeiffer of Edinboro University in Pennsylvania. The goal was to compare performance of “index” funds, which are less expensive because they do no research and simply track the performance of a well-known index, with “actively managed” funds, which operate under the belief that research into securities and opinions on the trend of the market can deliver better than average performance.

There’s a lot riding on this long-running debate—literally billions of dollars in research expenses, sales, and marketing expenses, and an entire industry that tries to convince investors that their approaches can “beat” the market—and thus are worth the payment of additional management fees.

This particular study was designed to test the specific idea that actively managed funds are worth those fees, especially in declining markets. The idea is that smart managers can protect a portfolio against the declines that occur in the general stock market, which are fully captured if you’re in an index fund.

Evensky explained the point of the study to me: “The motivation for the research was to test the hypothesis that although active management may not work in all markets, it shines during bear markets. The traditional argument is that active managers, unlike index managers, do not have to remain invested.”

The results were interesting. The research found that, on average, active managers do outperform the benchmarks in down markets—by enough to justify the additional fees. But if you look over a cycle of both recessions and expansions, the active fund managers fail to beat the market indexes when fees are considered.

While that may not be enough to convince the ordinary investor of the value of a well-known portfolio manager, there is another important aspect to this study. The real issue is whether you can pick the fund manager who will outperform consistently!

The study shows a wide range of performance between the best and the worst fund managers. And making the task of choosing a winning fund manager even more difficult, there is no reliable indication that the fund managers who perform well in one phase of the cycle, such as a recession, can translate that performance into the next phase—a period of growth.

In fact, the study shows that funds that performed well during a recession are unlikely to deliver a repeat performance during the next up cycle! Or as the red print on the cover of the mutual fund prospectus says: “Past performance is no guarantee of future results.”


Chasing Alpha
In stock market terms, the word “alpha” means “extra returns” or better performance. That’s basically the goal of most stock investors—to find a manager, or a trading system, that will help you beat the market averages or indexes.

Says Evensky: “Our conclusion is that it’s a good story [that portfolio managers do proved additional benefit in down markets] but not supported by the actual performance history of active managers during bear markets. Although some managers did indeed add alpha, it was just about enough to cover their cost with nothing left over for the investor. Adding insult to injury, there was tantamount to no survivorship; i.e., managers who did well in one bear market were not likely to do well in a subsequent bear market.”

So, if you want to devote your life to the study of the stock market, or to reading research reports, or studying stock charts, you’re more than welcome to accept the challenge of “beating” the market. I say this to forestall all the e-mails and blog postings that will surely arise to challenge the conclusions of this study—and my column.

But if you’re an individual investor, trying to figure out how to allocate your 40l(k) plan assets, this study should give you some comfort. This is not new! Back in the 1990s, investment manager Gary Brinson did a definitive study that showed asset allocation, not stock or fund picking, contributed to more than 90% of the difference in long-term returns.

Just Do It
Yes, it’s difficult to ride out a bear market. That’s the lesson learned since March 2009, when many investors panicked as the Dow fell to just above 6,500, where they sold out in fear. Since then, the market has climbed back to over 13,000—a double.

And now the fear of another potential decline is causing much anguish. But it’s equally difficult to call the tops or the bottoms—much less to “beat” the market during market cycles.

This might be a good time to remember that according to the Ibbotson historic figures, there has never been a 20-year period where an investor would have lost money in a “diversified portfolio of large-company American stocks, with dividends reinvested”—even adjusting for inflation.

The search for a way to beat the market over the long run is a lot more difficult than anything except your search for the self-discipline (or disciplined advice of a financial advisor) that keeps you consistently investing in the market itself—with an appropriate portion of your capital.

Just because you—and the pros—can’t all consistently beat the market is no reason to give up on regular investing to track market performance over the long run. And that’s The Savage Truth.