Introduction

Actively managed funds try to outperform both their benchmarks and other funds in their peer group. This is called alpha, returns on investment above the relevant, risk adjusted market index or benchmark.1

Active fund managers attempt to beat the market through two methods:

1. market timing, and
2. security selection

As of 2017, over $10 trillion dollars continue to be invested in actively managed funds.2 Starting with the assumption that markets are inefficient, a portfolio manager seeks be more heavily invested when the market is rising and less so when the market is falling and to identify stock pricing errors (either under- or over-valued stocks) before their peers do.

To justify active investing, all of the following must be true:

• Financial markets must be inefficient;
• That market inefficiency must be continually significant enough to justify the transactional costs, management fees, and taxes associated with active investing;
• You must identify the active manager, in advance, who will outperform the market net of those transactional costs, management fees, and taxes. (This introduces an additional risk, manager selection risk); and
• You must identify a successor active manager who will outperform the markets before your existing active manager’s performance falls below the threshold of the market benchmark plus costs, fees, and taxes.

As you will see, this is essentially impossible over the long term.

“Beating the Market”

Fifty years ago, individual investors did more than 90% of the trading on the NYSE. Today, over 98% of all exchange trades are by institutional investors, the majority of which is algorithmic trading. Fifty percent of the NYSE trading is by only 50 of the most active professionals. The securities markets are now global in scope, operating 24/7.3

Today, professional investors are the market. As a whole, they necessarily must earn the market return. Before considering costs, it is mathematically impossible for half of them to outperform the overall market at any given time.

Ironically, the more skilled and informed professional managers that enter a market, the more efficient the overall market becomes due to competition. This makes it even harder for active managers to find mispriced opportunities that justify the costs of active management. Active management may have been cost-effective thirty or fifty years ago, but not now in the liquid markets–such as stocks and bonds–in which individual investors should invest solely.5 For the investors using those professional managers, their returns must be the market return minus the transaction costs.6

According to David Swenson,

A minuscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent (annual) margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.7

Market Timing

Market timing includes:

1. the shifting of assets in and out of the market; and
2. the shifting funds between asset classes.

Market timing presumes that an active manager can predict the peaks and valleys of a financial market and profit therefrom. Market timing requires individual investors to deviate from their long-term asset allocation goals. As David Swenson describes, it may be a deliberate, speculative bet against the market. Or, it might be a significant passive drift of an individual investor’s portfolio beyond its target asset allocations, chasing performance.

Market timing fails over the long run because no professional is consistently more insightful about market shifts than the majority of his peers. Regardless of their motivation, the speculative winners are necessarily trading with the losers. And the odds of repeated success, quickly diminish the longer your investment time horizon.

Individual investors chasing past performance tend to hurt themselves the most. They overweight strong recent performers while underweighting weak recent performers. Due to the mean-reverting behavior of markets, this means they will have outsized holdings of assets with potentially poor future performance.8

Technical analysis is one form of market timing. It involves forecasting future price movements based on trading activity, including price movement and volume. In making the case against technical analysis, Burton Malkiel states,

If past prices contain little or no useful information for the prediction of future prices, there is no point in following any technical trading rule for the timing of purchases or sales. A simple policy of buying and holding will be at least as good as any technical procedure.9

Another form of market timing is when an investor stays in cash or comparable liquid asset or shorts an asset, anticipating a market downturn. This assumes that an investor:

1. can predict a downturn ahead of other investors (and contrary to market expectations factored into current asset pricing)
2. can predict when that downturn has bottomed out, and
3. if shorting a stock, can survive a margin call.

However, most stock market gains occur during the very first weeks of a recovery when the market timer is likely to be out of the market.10 Missing those rare days of significant gains means missing most of the overall market gain.1112 This defeats the purpose of avoiding the stock market and, instead, maintaining a cash surplus.

Security Selection

Security selection, also known as “stock picking“, involves an active manager selecting one or more stocks that are ‘undervalued’ and which will outperform the overall market over time.13 There are two approaches:

• constructing a well-diversified portfolio, or
• constructing a highly concentrated portfolio with a few stocks (a “focus fund”)

The more stocks that an active manager holds in a diversified portfolio, the more likely his portfolio returns will approximate the market average. This improves the risk-return ratio. However, given the costs of active management, this also diminishes the value of an investor preferring active management over a passively managed index.

Therefore, an active manager who is seriously committed to selecting securities must concentrate his holdings in just a few stocks if he is to outperform the market, thereby increasing his risk. However, there is no evidence that concentrating risk improves returns. To the contrary, well diversified funds outperformed focus funds. Fund performance is positively, not negatively, correlated with the number of funds in the portfolio. Focus funds have significantly greater volatility and tracking error as compared to their benchmark.14 Thus, focus fund investors are incurring greater risks while receiving lower returns as compared with index funds.

The results for actively managed bond funds are similar. Fixed-income managers argue that bond market inefficiencies give them a structural advantage over passive funds. Yet,  _____% of fixed income funds fail to beat their benchmark over a ten year period. Like equities, expense ratios are a good predictor of performance. (This is because actively managed bond funds underperformed by an amount approximately equal to fees).

The High Costs of Active Management

If you chose to have your savings actively managed, you must add the incremental costs of active management into your required return. No fund manager works for free. Earlier, we discussed the impact of financial intermediation and the importance of controlling your investment costs as the surest way to increase your investment returns.

Like John Bogle, Charles Ellis estimates that a typical actively managed fund’s costs exceed 3% per year. Assuming the stock market’s average nominal return of 9%, the active fund manager must return 12.25% or beat the market by over 34%. This is highly improbable at any given point and impossible over decades of active investing. Ellis determined that only 2% of funds were “above market” over a 20 year period. And, that assessment was before taxes.15

Funds usually calculate their fees as a percent of assets but you should calculate actively managed funds’ fees as a percent of risk adjusted returns above the market index. You are putting up all the capital and taking all the risk. Ask yourself, what is the actively managed fund’s incremental fee above an index fund versus the actively managed fund’s incremental return above an index fund (assuming that it even beat the index). If a fund charges a fee of 1% of assets and generates a 7% return on equities, the fund is charging 14%. If the fund charges more than 1% or underperforms the market average, then active investing fees can be considerably higher, even infinity if the fund loses money. FINRA has a useful fund fee comparison tool here.

The Tax Consequences of Active Management

Active management also incurs a tax penalty that must be factored into your required return. U.S. tax laws favor long-term gains over short-term gains, dividends, and interest income. First, capital gains are taxed at a lower rate. Second, capital gains are only taxed when you sell the asset. If you are a tax-sensitive investor, then you will prefer lower asset turnover of gains. Ellis states that active managers now turn over their portfolio by 100% each year. Ellis estimates that the tax consequences of fund turnover impacts active fund performance by as much as 3%.

The Difficulty of Selecting a Successful Active Manager in Advance

Over multiple decades, virtually all actively managed fund managers will fail to beat the market, particularly after taking into account their management expenses, transaction costs, and taxes. Both Malkiel and Ellis cite studies showing that for 90% of mutual funds future performance is totally random. A mid-2016 S&P Dow Jones Indices SPIVA US Scorecard shows:

During the one-year period, 84.62% of large-cap managers, 87.89% of  mid-cap managers, and 88.77% of small-cap managers underperformed [their respective S&P benchmark]. Over a five-year period, 91.91% of large-cap managers, 87.87% of mid-cap managers, and 97.58% of small-cap managers lagged their respective benchmarks. Similarly, over the 10-year investment horizon, 85.36% of large-cap managers, 91.27% of mid-cap managers, and 90.75% of small-cap managers failed to outperform on a relative basis.16

A 2015 Morningstar study also found that actively managed funds lagged their passive counterparts across nearly all asset classes across a ten year period.17

Selecting an Active Manager: Was Past Success Due to Skill or Luck?

Of all the legalese that you will encounter in investment documents, this is likely the most common disclaimer: “Past performance is no guarantee of future results.” Similarly, there is the maxim: “don’t chase past performance”. In other words, don’t expect a fund or an asset’s expected (future) returns to equal its historical returns. Notwithstanding, conventional wisdom suggests that if you desire to invest in an actively managed fund, then you should select a fund manager who has been successful in the past. After all, who would invest in a fund that has underperformed its benchmark?

Investment management success is due to a combination of both skill and luck. The problem is identifying whether a fund manager’s past success was due to skill or mere serendipity. Skill should be persistent. Luck clearly is not.

Bradford Cornell, a professor at California Institute of Technology, analyzed over 1000 mutual funds and concluded that 92% of the annual variation in performance was random noise. In other words, luck, not the manager’s skill.18 The law of averages means that some investment professionals will beat the market average before deducting management expenses, transaction costs, and taxes in any given year. Streaks can occur randomly with much greater frequency that you might assume. Flipping a coin a million times, the odds of twenty heads in a row is almost 38%.19 Barr Rosenberg asserts that it would take 70 years to conclusively demonstrate that even 2% incremental annual return was due to superior investment skill, not chance.20 Due to this randomness, it is impossible to identify the active manager in advance who will outperform the market net of fees and taxes in a particular year.

Similarly, Roger Ibbotson observed:

About three-quarters of a typical fund’s variation in time-series returns comes from general market movement, with the remaining portion split roughly evenly between the [fund’s] specific asset allocation and active management.21

Timing the Selection of a Replacement Active Manager

There is no consistency over the long term that high performing funds and their managers will continue to out-perform. This is true even before considering survivorship bias and new fund bias in data on funds. Further, reported time periods tend to be too short and sample sets tend to be subject to sampling error, preventing objective comparison.

Active fund investors must regularly select a new fund manager even when their current funds have out performed the overall market. Morningstar found that top performing (“5 star”) funds did worse the following year than the lowest (“1 star”) funds. Individual investors in actively managed funds hurting their returns the most because they tend to time their fund selection on a lagging basis to the market cycles.

Individual Investors Cannot Compete with Institutional investors

Institutional investors–including banks, mutual funds, pension funds, hedge funds, REITs and endowments–have access to the best research, the sharpest analysts, and the best technology. The typical individual investor has a day job apart from investing for their retirement. They may have learned a lot about their company or industry. But they lack the broad market knowledge, the tools, and analytics of their institutional counterparts.

As Warren Buffet advises,

A lot of very smart people set out to do better than average in securities markets. Call them active investors. Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore, the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors. Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor’s equation. Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested. A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds.2223

Summary

It is nearly impossible for actively managed funds to beat a liquid market’s average over the long-term after taking into account management expenses, transaction fees, taxes, and risk. Because all stocks must be owned by someone, active management is therefore a negative-sum game. Winners’ winnings must equal losers’ losses.24 Then, there is leakage associated with fees and taxes.

Instead of employing short term tactics like trying to beat the market through active investing, you should focus on four strategic imperatives:

1. identifying your overall investment policies and constructing your optimal asset allocation,
2. reducing your investing costs,
3. minimizing your asset turnover (and therefore your taxes), and
4. sheltering your gains in tax deferred accounts

For More on this Topic

Updated on October 19th, 2019