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Passive investors sow seeds of their own demise

(MoneyWatch) Brian Frank, president and portfolio manager at Frank Capital Partners LLC, contends that passive investors are headed for a bleak future. In an article he wrote for InvestmentNews, he states: "When passive investors take over, great destruction results." Adding that a "critical mass of valuation-agnostic, passive investors" have saturated the U.S. stock market with the result that "the rational scientists of active managers setting prices are losing control to the chaotic, passive-investing" investors who "by forgoing valuation, sow the seeds of their own demise." Frank views the "prevalence of passive investors as a tremendous opportunity for stock-pickers." Since it's clear we, the passive bunch, are headed for demise, I'm not sure there's even reason to object to Frank's claims ... but I'll do my best.

Check the score

Let's take a look at the evidence. As Frank noted, 10 years ago passive investors controlled only about 20 percent of assets. That figure is now up to about one-third of assets. Why the trend? Perhaps it's because investors, both individual and institutional, are fed up with the persistently poor performance of actively managed funds.

If passive investors were actually sowing the seeds of their own destruction, we would see that in the outperformance of active funds. Yet every six months the S&P Indices Versus Active funds scorecard (SPIVA) shows that not only do a large majority of active funds underperform anywhere we look, but there's also no persistence of outperformance beyond the randomly expected -- making past performance an unreliable guide to future performance.

Bury the dead returns

Frank goes on to make a litany of excuses for the underperformance of active managers. As usual, those excuses hold as much water as a sieve. Let's look at some of them. He blames the flow of assets into index funds for distorting prices and hurting stock pickers in the short run -- though he claims it helps them in the long run. Unfortunately for Frank, the evidence from the SPIVA shows that the longer the time frame we look at, the worse the performance of active managers. As further evidence, a recent report from Dimensional Fund Advisors showed that for the period ending December 2012, the one-year results for stock mutual funds showed just 37 percent of funds beating their benchmark. On top of that, 6 percent of funds failed to survive, presumably because of poor performance. For the five-year period, the figures get worse. Just 25 percent of funds outperformed, and 30 percent of funds disappeared. For the 10-year period, just 17 percent beat their benchmarks, and an astonishing 51 percent of the funds that existed during the period had been sent to the mutual fund graveyard, where their lousy returns are buried. The results were basically the same for active bond funds. If Frank's hypothesis was correct, the trends would be in the reverse direction, with a higher percentage of winners the longer the horizon.

Master of delusion

Frank also points to the bear market of 2000-2002 and the performance of the S&P 500 index. He states: "Numerous investors have forgotten that those who remained indexed at high valuations in the year 2000 suffered three straight calendar years of declines, with a cumulative loss of 40 percent. At the same time, numerous active investors posted flat to positive returns by avoiding the distorted, booming, overvalued companies. Indexers were finally made whole ten long years later, little consolation for the lower fees." This is a classic misdirection on two fronts. First, the evidence from many studies shows that as poorly as active managers do in bull markets, they actually tend to lag even more in bear markets.

Lipper, a Thomson Reuters service, studied the six market corrections (defined as a drop of at least 10 percent) from August 31, 1978, to October 11, 1990, and found that while the average loss for the S&P was 15.1 percent, the average loss for large-cap growth funds was 17.0 percent. Fund managers fared no better in the bear market of July-August 1998. The average equity fund lost 19.7 percent. This compares to losses of just 17.4 percent and 15.4 percent for a Wilshire 5000 index fund and an S&P 500 index fund, respectively. And consider this bit of amazing evidence. Goldman Sachs studied mutual fund cash holdings from 1970 to 1989. The study found that mutual fund managers miscalled all nine major turning points. You couldn't get all nine turning points wrong if you tried!

As further evidence, a 2009 study by Vanguard found that active managers don't outperform in bear markets, and the ones that do in one bear market show no persistence in the next. Vanguard, which runs many active funds, came to this conclusion: "We find little evidence to support the purported benefits of active management during periods of market stress."

Frank's second attempt at sleight of hand was to hope that you would make the mistake of confusing indexing with the exclusive use of the S&P 500 index. Those active managers who outperformed the 2000-2002 bear market almost certainly did so because they were value investors, not investors in the large growth stocks that dominate the S&P 500 and the total-market indexes. Consider the following: From 2000-2002, while the S&P 500 and the Russell 3000 lost a total of 37.6 percent and 35.7 percent, respectively, the Russell 1000 value index lost just 14.7 percent, while the Russell 2000 value index actually returned +24.0 percent. Those "valuation-agnostic, passive investors" in a passively managed small-cap value fund would have outperformed the S&P 500 index by about 60 percent!

Frankly, my dear ...

Frank concludes with this warning for passive investors: "Changes in markets are often volatile and violent, and passive investors claiming the ability to 'pull the plug' at the sight of trouble may be shocked by the speed a distorted market can correct." Passive investors acknowledge that they will not be able to pull the plug ahead of a bear market -- they know there are no clear crystal balls. Their investment plans incorporate the certainty that there will be bear markets that they will have to live through with equanimity. While others, including active managers, are losing their heads engaged in panic selling, passive investors are buying when prices are low and expected returns are high. They do so not because they believe they can predict the bottom, but because they will be rebalancing, adhering to their plan.

Before closing I thought it would be appropriate to check the performance of the mutual fund Frank runs, the Frank Value Fund (FRNKX). The investor share class of the fund returned 8.11 percent from July 2004-June 2013. Given its self-description as a go-anywhere value fund, we'll compare this return to the returns of the passively managed Dimensional Fund Advisors large value (DFLVX) and small value (DFSVX) funds. DFA's returns data is from August 1, 2004, so there are slightly different dates. However, the market was virtually unchanged during the nine missing days. DFSVX outperformed, returning 8.31 percent, while DFLVX underperformed, returning 7.61 percent. The two DFA funds provided an average return of 7.96 percent. Basically, we have a draw here. Despite Frank's claims of all the advantages active investors have, he hasn't really shown any ability to exploit these valuation-agnostic investors. Perhaps, we're not as doomed as he thought.

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