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The lies active managers tell

I was doing research on an article about active management when I came across an Investment News article from earlier this year titled "Active Managers Can Add Value." The article was written by two members of an investment firm that actively manages portfolios, using value strategies. The more I read, the more upset I became. As we look at some of the claims it made, hopefully, you'll understand why it disappointed me.

Chance of outperformance

Although active management is a little more expensive and sometimes riskier, skilled active managers can enhance investors' wealth.

On the surface it's a true statement. However, while providing the possibility of benchmark-beating performance, there's an overwhelming body of evidence that the odds of a portfolio of actively managed funds will outperform is so low that it's simply not prudent to try, especially for taxable investors. Possible, yes. Likely, no.

Even active manager and AJO founder Ted Aronson, of Aronson+Johnson+Ortiz, stated: "None of my clients are taxable. Because, once you introduce taxes ... active management probably has an insurmountable hurdle. We have been asked to run taxable money -- and declined. The costs of our active strategies are high enough without paying Uncle Sam." While it's possible to get rich at the racetrack or through the lottery, prudent investors don't use these for retirement accounts.

Evidence on both sides

Many studies make compelling cases for both sides, but one can't be proven superior.

This is simply not true. I've read hundreds of studies -- enough to fill an entire book ("The Quest for Alpha") -- over the years, and not one has shown that active management is likely to be the winning strategy. This is true whether we look at mutual funds, pension plans or hedge funds. Even venture capital, once returns are adjusted for risk, has failed to outperform publicly available small value stocks.

Only investing in a single index

In fact, rather than buying the market, passive investors replicate the holdings of a specific index, with most invested dollars indexed against just 500 stocks.

Just a quick check of Vanguard fund's assets under management would show that this is almost certainly wrong. For example, Vanguard has more in assets in its US Total Market Fund (VTSMX) and its Emerging Markets Index Fund (VEIEX) than it does in its S&P 500 Index Fund (VFINX). That's not to mention its small-cap, value and real estate index funds. And then there are fund families such as Bridgeway, Dimensional Fund Advisors, Wisdom Tree and RAFI that collectively manage hundreds of billions in passive strategies, yet have almost no assets in the S&P 500. (Disclosure: My firm, Buckingham Asset Management, uses DFA and Bridgeway funds in constructing client portfolios.)

Owning expensive stocks

Indexes contain all stocks in proportion to their market cap. The costliest have the highest weight.

The implication is that you own more of the stocks that are the most mispriced/overvalued. This is just a false statement. If that were true, it would obviously be easy for smart active managers to simply underweight those same stocks and beat the market. Yet there's no evidence they can. In addition, there's nothing to prevent the smallest stocks in an index from being the most "mispriced" or overvalued. I would also add that the RAFIindexes don't even market cap weight but use a fundamental weighting strategy. (However, I don't believe there's evidence that a fundamental weighting strategy adds value relative to a market cap weighting strategy.)

Owning stocks after they've gone up

Last March, Apple was at about $610 and made up about 4.4 percent of the S&P 500. Three years earlier, it had been $110 and made up 1.4 percent. Does anyone want to own three times as much Apple after it has been up 450 percent?

Who do you think drove the price of Apple (AAPL) to the higher levels? Of course it was the active managers, who now owned three times as much Apple as they did before. Passive investors are just price accepters, not price makers.

Exploiting mispricings

The flows into passive vehicles mean that active managers have less influence at the margin to move prices to reflect the true value. Outflows from actively managed funds exacerbate the mispricing, as attractively valued stocks must be sold to raise cash. ... This process creates more mispricing opportunities for active managers to exploit. ... Sector exchange-traded funds give retail investors focused chances to buy high and sell low as they become interested in a sector after a period of strong returns. Large inflows not only create mispricings in stocks but may make whole sectors unattractive.

Each of these statements has the same fundamental flaw. If these were true, the trend toward passive investing would mean that we would be seeing more and more active managers outperforming as more and more mispricing occurred. Yet there is absolutely no evidence of that, as anyone who follows even the S&P Indices Versus Active scorecards (SPIVA), let alone the academic literature, would know. Second, while the percentage of money under passive management has risen (though at a glacial pace of perhaps 1 percent a year), the amount of trading has increased greatly. And, remember, it's the active traders that set the prices, not the passive investors.

The one true statement in the article was that active management does provide the possibility of benchmark-beating performance. Unfortunately, the far greater likelihood is that it will produce below-benchmark results, especially for taxable accounts. Making matters worse, the evidence also demonstrates that on average the small number of winners have much smaller positive alphas than the larger number of underperformers have negative alphas. There's an old saying about it being hard to get someone to see the truth when their livelihood depends on the falsehood. Keep this in mind the next time you read about the supposed virtues of active management.

Image courtesy of Flickr user 401(K) 2013.
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