The Case Against Active Management
Dozens of academic studies over the years have examined how efficient the markets are by looking at the performance of professional money managers. The studies discussed below dating back to the late 1960’s present evidence that out-competing the market is difficult to do on a consistent basis.
Luck Not Skill
In 1969, Michael Jensen of Harvard Business School wrote a paper published by the Journal of Finance in which he developed a risk adjusted measure of portfolio performance based on the theory of the pricing of capital assets by Sharpe (1964). The measure now known as “Jensen’s Alpha” estimates how much of a manager’s skill to pick stocks or time markets contributes to a fund’s return. Jensen applied the measure to estimate the forecasting ability of 115 mutual fund managers between 1945 and 1964. He questioned their ability to earn returns which are better than would be expected given the level of risk in each of the portfolios. Jensen found that the sample underperformed a buy-and-hold strategy (1945-1964), and individual performance was no better than what could be predicted by random chance (in other words, it was luck, not better stock picking).
Winners Don’t Repeat
Several later studies found evidence of persistence among winners; funds with unusually high returns tended to have high returns in the following periods. This result is repeatedly cited as confirmation that some managers are more skilled than others. One exhaustive study (Carhart, University of Chicago dissertation, 1997) specifically addressed survivorship bias and distinguished skill from simple momentum effects. Carhart showed that persistence was determined mainly by short-lived momentum in a fund’s underlying securities. Mangers don’t effectively exploit momentum to enhance returns. Rather, Carhart’s research demonstrated that some of the stocks that manager’s own fortuitously develop upward momentum. When the momentum on those stocks decays, so does the superior performance of the manager. The bottom line to Carhart’s research is that Investors cannot identity superior managers by looking at past returns.
Carhart found that an equal-weighted portfolio of 1,892 funds existing at any point in time between 1961 and 1993 underperformed the market by 1.8% per year after adjusting for common factors in returns. Think about that. The universe of actively managed funds available to investors over that long period of time produced a collective annual shortfall of nearly 2%. Short and long-term capital gains, which are less an issue for passive investors, further erode the returns of the active investor.
Survivorship Bias Inflates Past Performance
A 1998 study looking back at two decades of mutual fund performance (Arnott, Berkin and Ye, 2000) demonstrated that on whole, actively managed funds underperformed the Vanguard 500 (an index fund) by 2% annually over 20 years. Over 15 years the performance record compared to Vanguard was -3.73%, and at 10 years, it was -3.18%. The results are actually worse than that, as this study failed to take survivorship bias into account. This means that the funds that simply failed and disappeared completely weren’t accounted for. Results were even worse when capital gains and dividends taxes were included. In this study, just one in ten mutual funds outpaced the S&P 500. A large body of research suggests that the under-performance of actively managed funds is between 1.5% and 2% annually when comparing the same asset classes and mix.
Active Small Cap Managers Fail to Outperform their Benchmarks
Investors often argue that small cap stocks are more inefficiently priced than large cap stocks, so that the pricing errors can be more easily be exploited. This suggests there should be evidence of persistence among small cap portfolio managers. However, no real evidence of reliable positive persistence exists among small cap managers according to studies by Davis (2001) and Quigley and Sinquefield (2000).
Active Bond Funds Cost Society $1.4 Billion Annually
In a well constructed study Maralena Lee (2009) examined the role of luck in the performance of actively managed US bond funds from 1991 to 2008. At the end of 2008, there were 1,476 actively managed bond mutual funds in the US, with total net assets of $158 billion. Lee (2009) studied the performance of these professional bond managers. In aggregate, Lee found that bond funds underperformed, by an amount roughly equal to their fees. Additionally, good past performance did not predict good future performance. According to Lee, the top decile of funds sorted on abnormal results in the previous three years had insignificant alphas in the following six months. In contrast, the poor performance of the biggest loser persisted for several years.
These results show that investors cannot expect to profit from investing in actively managed bond funds with good past performance, and they may be able to protect themselves by avoiding actively managed bond funds with poor past performance (Lee, 2009). Collectively, investors in active bond funds lost about 90 basis points per year, or about $1.4 billion in 2008, in under-performance. This under-performance was primarily driven by fees thereby negating the argument that higher fees associated with active management reward investors with above average returns.
Active Management Accelerates Taxation
With active trading, portfolio turnover is a given. For instance, the average turnover rate for US large caps was 79% in 2009. This is not good news for investors who hold funds in taxable accounts—and taxable accounts hold nearly two-thirds of all mutual fund assets. Turnover accelerates taxation, costing fund holders 1% to 2% annually in estimated capital gains taxes. According to a 1993 study by Arnott and Jeffrey, even modest turnover of 10% can reduce returns by a full percentage point. To achieve 6% after-tax growth, an active fund would have to outperform its passive counterpart by anywhere from 70 basis points (for a portfolio with 5% turnover) to 278 basis points (for a portfolio with 50% turnover).
The main message of the performance studies is that it is very difficult to beat the market by collecting and evaluating information. The average mutual fund fails to outperform a style adjusted passive benchmark. There is little evidence of persistence in good performance when returns are adjusted for common risk factors and the effects of momentum. Some managers may be more talented than others, but the reward for their effort isn’t large enough to cover the higher costs of the active management process. Yet active investing continues to appeal to the widespread belief that with the right adviser, strategy, timing, stock tips, or hunch, investors can beat the market. This belief is aided by a multi-billion dollar financial industry that pumps out misleading advertising and is also fueled by business and money magazines, subscription newsletters, TV financial gurus, local investment clubs, blogs, and rating services like Morningstar.