A client recently sent me a paper forwarded to her by an advisor. The Goldman Sachs "Market Insights" paper, issued in February 2009, claimed "we believe there are several reasons why active management is poised to succeed." Let's examine the logic of each of the five reasons, and then see how Goldman Sachs has done with active management.
As you read each of these reasons, keep the simple arithmetic in mind that whatever the market returns, the average investor will pocket that market return minus the costs they pay to the experts managing the investments. Put another way:
Market Return - Costs = Investor Return
Remember that this equation holds in any market, irrespective of the market's volatility and future direction. And keep in mind that roughly 90 percent of the market is professionally managed and logic dictates that they can't all be above average.
Reason 1: Having experienced extremes, volatility should continue normalizing, leading to greater stock-level dispersion.
While Goldman Sachs called the decline in volatility right, their claim that "this creates a fertile environment for stock picking" seems unsubstantiated, in my view. This is a leap to say that arithmetic will no longer work with lower volatility.
Reason 2: The prospects for Broad Multiple Expansion Appear Limited.
They called this quite wrong as the stock market was just about to go on a 76 percent tear after bottoming out on March 9, 2009. Still, their claim that this creates prospects for determining which stocks have more meaningful appreciation opportunities completely escapes any logic I can think of.
Reason 3: In this economy, there will be market share gainers and losers.
I'll put this in the "duh" category. Every market at any given time will have market share gainers and losers. They claim that a "rising tide lifted all boats" in the bull market between 2003-2006. Not realizing the fastest bull since the great depression was about to hit, then noted that performing an in-depth, forward looking, and company specific fundamental research could help a manager pick the winners and avoid the losers. Even if they had been right about no broad market expansion, active investing is always about picking winners and avoiding losers. Why should the bleak track record of active investing, and a simple rule of arithmetic, suddenly change in the current economy?
Reason 4: There will be recovery, though it is likely to be different than the last one.
Every bull market and every recovery will always be different than the last one, so this is another "duh" moment. Sure, Goldman Sachs got this right, but it led to their prediction in reason #2 that no broad market expansion was likely. Yet again, they fail to explain why this knowledge would lead to a better time to be active.
Reason 5: Dramatic growth in indexed assets creates stock-level inefficiencies.
Goldman Sachs claims the past has been catalysts that buoyed the case for passive investing. Because the assets and number of index funds has grown, Goldman Sachs notes that this creates stock price inefficiencies. I'd give them this one if 90 percent of assets were in index funds, since that would leave little for trading. Indexing is far below that level as, last I heard, active managers were still making a bundle from their advice, even with their declining market share. Could it be that indexing is growing because we don't live in Lake Woebegone and active managers as a whole must underperform the broad indexes?
If my logic hasn't convinced you then here is some data that might. Let's look at how Goldman Sachs has done with their stock picking. Goldman Sachs has a mutual fund family with over $58 billion in assets that has bested the average mutual fund in its equivalent category in only one of the last five years, according to Morningstar. Its average US equity fund has a Morningstar average rating of 3.2, slightly above average while its average international fund has a dismal 2.4 rating. We all know that most mutual funds underperform the index but it appears the Goldman Sachs stock picking didn't even meet an average mutual fund, overall.
Taking a look back at 2009, a broad US Stock fund like the Vanguard Total Stock fund (VTSMX) bested 60 percent comparable funds, and the International Stock Index fund (VGTSX) bested 80 percent of those active managers. Try as they might, the mighty titans of Wall Street were again unable to overturn simple arithmetic. Remember, when Goldman Sachs wins, investors lose.