Another Failure for Active Management

I love talking with investors who believe in active management. I love hearing about their theories for unearthing tomorrow's winners. I love hearing them talk about what they think the market has in store, and why they're so sure it will happen.

But most of all, I love hearing about their "system." Almost every active investor I've ever met has one. Though they tend to be vastly disparate -- and can take into account everything from economic indicators to stock volumes to what phase the moon is in -- these systems are ever-evolving models that distill a range of information and data points into a buy, sell, or hold recommendation.

Of course, the idea that one can take an assortment of publicly available information and divine the direction of the stock market is silly. As my colleague Larry Swedroe has pointed out a number of times, there are tens of thousands of highly trained, highly intelligent professionals whose compensation models highly incentivize them to find the tiniest edge in outsmarting the market. Given their documented futility, I'm skeptical that Carl in accounting has figured out something that Wall Street's army hasn't by spending a weekend pounding on his Dell laptop.

A fine example of that futility was provided last week when Vanguard announced that it was making changes to its Asset Allocation fund. The fund, which was launched in 1988, is a balanced fund that tracks the S&P 500 on the equity side, and the long-term Treasury bond market on the bond side.

What made this fund unique was the leeway its managers were provided. They could go from 100 percent stocks to 100 percent cash based upon their outlook for the stock and bond markets. Their proprietary model estimated expected near-term returns for stocks and bonds, and adjusted the fund's allocation to maximize its return.

This model wasn't built by your buddy Carl in his basement. The fund's managers had many years of experience, and were supported by a deep team of analysts, traders, and economists, who doubtless poured more data than mere mortals could conceive into their quantitative model. And their compensation was strongly linked to their ability to finely tune that model, allowing it to profitably shift the fund's allocation between stocks, bonds, and cash.

The problem, as you may have guessed, is that they weren't very successful in doing so. The fund has lagged 96 percent of its peers over the past five years, and 79 percent over the past decade, and, even worse, has taken on more risk than its peers to earn those disappointing returns.

That record spurred Vanguard to announce last week the first steps to merge the fund out of existence, with the plan to merge it into the firm's Balanced Index fund.

Thus we have yet another example of just how difficult it is to devise a way to outsmart the market. True, the failure of Asset Allocation fund probably won't convince the true believers among us to give up their chase for outperformance. But if nothing else, it provides a further bit of affirmation for the rest of us that we don't have to reconsider our decision to opt-out of the chase.

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