More Evidence of the Folly of Active Management

Last week I discussed some screens that investors might use to separate those fund managers who might have a fighting chance to outperform the market over the long-term from those whose chances range from slim to none. This week I'll revert to form, and take a look at the difficulty that any investor faces when they go the active management route.

That difficulty is reinforced quarterly by the Standard & Poor's SPIVA Scorecard. For those unfamiliar with the SPIVA scorecards, they report the percentage of actively managed funds that were outperformed by their benchmarks over the trailing one-, three-, and five-year periods. The most recent five year figures -- shown in the table below -- are particularly interesting because they fly directly in the face of two well-honed critiques of indexing: 1) that indexing only works in bull markets (the overall market was down ten percent during this period); and 2) that indexing only works in "more efficient" segments of the market (the majority of active managers in 11 of the 12 style boxes trailed their benchmarks).

Over time, as funds with poor records are liquidated or merged into other funds, their performance records are struck from most mutual fund databases. Thus, if we look back today at the return provided by the average actively managed fund in 2001, that figure will not reflect the horrendous returns turned in by the hundreds of funds that were around in 2001 but have folded since then -- only the survivors' returns are included. Because of that, the historical performance of actively managed funds can be inflated by as much as 4.5 percent annually. The S&P's report eliminates this upward bias by including the returns earned by the funds that have disappeared over the years.

But the SPIVA reports also present two additional illustrations of the challenges presented by using actively managed funds. First, they report on each category's survival rates (i.e. the percentage of funds in each category that were merged or liquidated).

Consider the five-year survival rates of large-cap blend funds. S&P reports that since June 2004 only 61 percent of funds that began the period are around today. Thus, in 2004 the average large-cap blend investor faced a nearly 40 percent chance that their fund would fold within five years. Assuming that survival rate remains the same for the next five years, nearly two-thirds of all large-cap blend funds would fail to survive the decade. Forget finding a winner -- you're beating the odds if you merely select a survivor.

Second, the SPIVA report also highlights the tendency of actively managed funds to drift from one style to another over the years.

Some investors who eschew the idea of indexing the entire U.S. stock market like "go anywhere" managers, and give them free rein to choose the market styles and sectors they find most compelling. But many investors carefully construct their portfolio by size -- allocating a certain percentage of their assets to large-cap and small-cap stocks, for instance -- and style -- overweighting value stocks or growth stocks.

The problem with using actively managed funds to implement such a strategy is that while your desired portfolio weights presumably remain relatively constant over time, the funds that you choose to implement your plan are unlikely to cooperate -- a small-cap fund might become a mid-cap fund, for example, or a large-cap growth fund might become a large-cap blend fund. According to the S&P report, nearly 48 percent of all domestic equity funds changed styles over the past five years.

This can be more than a minor aggravation; you can find yourself unwittingly taking on more risk than you bargained for. If your ostensible large-cap fund manager decides to make a bet on some of the seeming bargains he sees in the small-cap sector, you're along for the ride, with a portfolio that's suddenly overweight in the riskier small-cap sector and underweight in large-cap stocks.

This may sound like a trivial point, until you recall that shareholders of many large- or mid-cap funds found their portfolios overweight in suddenly small-cap financial firms last summer because their fund managers couldn't resist the apparent bargains the market was tempting them with.

So the next time you find yourself intrigued by the latest fund manager who has captured everyone's fancy with a few months of stellar returns, do yourself a favor and take a look at one of the S&P SPIVA reports, which should serve as a helpful reminder of just how fleeting those returns -- and even the funds themselves -- are likely to be.