Do Current Conditions Favor Active Management?

(MoneyWatch)  The site On Wall Street had an item about a report stating that now is a good time for active managers to demonstrate their value, claiming this is a stock picker's market. Unfortunately, there's no such thing as a stock picker's market. That too is just another myth, and it can be proven with simple addition.

This article notes that 64 percent of equity funds beat their benchmarks through the first five months of the year. David Daglio, senior vice president of the company that released the study, Boston Company Asset Management, said in a statement that, "The early part of 2009 appears similar to other periods that we have studied, where market distress has created exceptionally wide valuation spreads across the marketplace."

The Mathematics of Investing A simple example will demonstrate that active investing must, in aggregate, be a loser's game. The market is made up of only two types of investors, active and passive. Let's assume that 70 percent of investors are active and 30 percent are passive. (It doesn't matter what percentages are used; the outcome is the same.) Assume the market returns 15 percent. On a pre-expense basis, a passive strategy such as owning a total stock market fund must earn 15 percent.

What rate of return, before expenses, must the active managers have earned? The answer must also be 15 percent. The following equations show the math:

1. A=Total Stock Market, B=Active Investors, C=Passive Investors
2. A = B + C
3. X = Rate of return earned by active investors
4. 15% (100%) = X% (70%) + 15% (30%)
5. X must equal 15%

In aggregate, on a pre-expense basis, active investors earn the same market rate of return as do passive investors. Note that it doesn't matter which asset class we're discussing; the math is exactly the same. The same thing is true for bull and bear markets -- change the +15% to a -50% and you get the same result. Active management must earn the same pre-expense gross returns as passive management. However, since their costs are higher, they produce lower net returns.

Now matter how hard they try to spin the data, the laws of simple arithmetic hold. There's no such thing as a stock picker's market. If a study claims otherwise, it hasn't used the correct benchmarks.