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Research shows bumpy road for active investors

(MoneyWatch) While there's a clear trend toward passive investing -- every year since 2006, passively managed funds have seen net inflows, while actively managed funds have seen net outflows -- about three quarters of individual investor assets are still in actively managed funds. Investors in actively managed funds are either unaware of the vast body of research showing that, on average, actively managed equity mutual funds underperform their respective benchmarks, or, in a triumph of hope, hype and marketing, they ignore the evidence, believing that somehow they can identify the few winners ahead of time. A July 2013 report from the research department at Vanguard provides further insight into just how high the hurdle is that investors in  managed funds face in their quest for outperformance. The study covered the 15-year records of all actively managed U.S. domestic equity funds that existed at the start of 1998. The following is a summary of their findings:

  • We confirm prior research indicating that only a minority of active managers outperform relevant style benchmarks.

  • Even before considering the impact of taxes, long-term outperformers are rare, accounting for only 18 percent of funds. The percentage of funds that did not even survive the full period was 2 1/2 times as great (45 percent), as 700 of the 1,540 funds were either merged or liquidated.

  • Even for the winners, the mean outperformance of the winners was just 1.1 percent a year.

  • 97 percent of funds underperformed in at least five of the 15 years, and 60 percent had at least seven years of underperformance.

  • Even the few winners experience numerous and often extended periods of underperformance. Nearly every one of the successful funds underperformed in at least five of the 15 years through December 2012, and two-thirds of them experienced at least three consecutive years of underperformance during that span. That means that just 6 percent of the funds that began the period avoided three consecutive years of underperformance.

Such periods of extended underperformance not only test the discipline of investors, they also call into question the issue of how long to wait to determine whether the fund manager has the skill needed to generate alpha. For many investors (including pension plans and endowments), three years, let alone three consecutive years, of underperformance represents a break point after which they will divest the fund. With two-thirds of the winners experiencing such periods, it seems unlikely that many investors actually stayed around for the full 15-year period.

Vanguard noted: "Standardized performance reporting, which displays a single annualized return for a multiyear investment period, may mask these spells of underperformance. When investors simply see an average annualized 10- or 15-year rate of return, they may not be fully aware of the highs and lows that occurred along the path to that average." They observed: "Investors pursuing outperformance not only have to identify winning managers, but historically have had to be very patient with those managers to collect on their success."

Vanguard concluded: "The random pattern of excess returns among the ten funds also highlights the challenge of 'timing' managers, a strategy in which investors readily move from one fund manager to another in an attempt to improve performance. Manager timing can be very tempting to investors focused on short-term performance, but it's a strategy that prior research has shown to be generally unsuccessful."

If you've been playing this "loser's game" -- it's not impossible to win, but the odds of doing so are so poor it's imprudent to try -- it's time to reconsider the evidence and the odds of your actually outperforming.

Image courtesy of Flickr user Brron.

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