Last Updated May 6, 2010 9:45 AM EDT
Active managers know the evidence doesn't support their strategy as the winning one. Thus, they have to tantalize you with the possibility of outperformance. Consider the case of Waddell & Reed, who claim active management is the way to go, even though the data shows otherwise.
The firm has a paper on its Web site titled "Active vs. Passive Investment Management." Here's what they say about active and passive management:
"Active management has a definite allure...Active managers use sophisticated, technical tools and analysis to help them find stocks that they believe offer a sustainable competitive advantage...They can often sidestep troubled areas of the market and can aggressively pursue perceived opportunities, which then provides the ability to potentially outpace the market."
"Buyer beware: Passive management is a buy-and-hold approach that may prevent an investor from ever outperforming the market. Forfeiting an opportunity for above-market returns is a risk for investors with aggressive investing goals, and a potential liability during extended bear markets. Their managers cannot capitalize on market inefficiencies, which are often abundant during down markets or periods of economic recession, nor can they take defensive action, such as moving out of a given sector or industry if they anticipate negative performance. When it comes to returns, investors in passively managed funds have to be content with whatever the market returns, because that's generally the best they'll do -- ever."
Let's expose a few of the many problems with the article.
First, yes, active management has an allure. However, the historical evidence is overwhelming that its allure has the same dangers as the allure of the sirens Odysseus confronted. While you have the possibility of market-beating performance, the odds are much greater that you will underperform. That's why active management is like playing the slot machines in Las Vegas - while you can win, the odds of doing so are so low that it's imprudent to play.
Second, while passive investing means giving up the opportunity to outperform the market, it more importantly avoids the far greater risk of underperforming the market. And the evidence shows that the vast majority of mutual funds, hedge funds and individual investors underperform the market.
Third, as we have discussed many times, while the market isn't perfectly efficient, there's no evidence that active managers can persistently exploit any efficiencies. Even behavioral funds, whose strategies are based on exploiting known anomalies, have failed to deliver market-beating returns.
Let's consider the results of Waddell & Reed's own efforts to beat the market. We'll look at their broad based funds and compare them to comparable index funds from Vanguard, using data from Morningstar. The period will be the 10 years ending March 16.
Intermediate-Term Bond Funds
- Waddell & Reed Bond Fund (UNBDX) -- 5.3 percent per year
- Vanguard Intermediate-Term Bond Index Fund (VBIIX) -- 7.0 percent per year
- Waddell & Reed Accumulative Fund (UNACX) -- -1.8 percent per year
- Waddell & Reed Core Investment Fund (UNCMX) -- 0.1 percent per year
- Waddell & Reed Vanguard Fund (UNVGX) -- 0.6 percent per year (Please note that this fund is not associated with Vanguard.)
- Vanguard Total Stock Market Fund (VTSMX) -- -0.1 percent per year
- S&P 500 Index Fund (VFINX) -- -0.6 percent per year
- Waddell & Reed International Growth Fund (UNCGX) -- -1.8 percent per year
- Vanguard Total International Stock Index Fund (VGTSX) -- 2.6 percent per year
- Waddell & Reed Small Cap Fund (UNSAX) -- 2.6 percent per year
- Vanguard Small Cap Index Fund (NAESX) -- 4.0 percent per year
- Waddell & Reed Value Fund (WVAAX) -- 1.5 percent per year
- Vanguard Value Index Fund (VIVAX) -- 1.0 percent per year
The bottom line is that Waddell & Reed's funds haven't actually lived up to the claims that active managers can capitalize, as its article states, "on market inefficiencies, which are often abundant during down markets or periods of economic recession, nor can they take defensive action, such as moving out of a given sector or industry if they anticipate negative performance." This is why I believe active investing is the triumph of hype, hope and marketing over wisdom and experience.
For further reading, see my post on how Waddell & Reed's Ivy funds compare.