The Folly of Active Management

By Allan Jaster, Principal, Archer Consulting Group

Allan CropOne of the longest standing debates around the office coffee pot is “which is a better investment strategy – Active Management or Passive Management?” Though much debated, when you sit down and look at the facts, it’s not even close! When it comes to risk adjusted returns and cost effectiveness Active Management is inferior to Passive Management. I’m consistently amazed at how skilled the financial media is at shaping this debate and subsequently swaying investor activity. Why? Active Management is a much easier sell to investors and it’s more profitable to the financial industry. So it shouldn’t surprise you that even with a historical mountain of facts screaming that the Passive approach is superior… over 95% of all mutual funds are still actively managed.

The term “Active Management” translates to “selection and timing”. In other words, if you’re an advocate of the Active Management style you believe that there’s a person (or group of people) using fundamental and/or technical analysis to determine which securities to buy or sell… and when to do it. For that, of course, there is a substantial cost. But the idea is that the research pays for itself above and beyond what it costs. So far so good.

The entire foundation of Active Management starts to fall to pieces when investors start comparing their mutual fund to its benchmark – (think “S&P 500”.) Of course, the idea is that the Actively Managed fund beats the benchmark– especially since it costs more. This is the entire premise of having an active fund manager right? Otherwise we’d all just be better off owning the boring benchmark. How are fund managers doing? Turns out – they are not doing too well.

This chart (right) is taken from the Center for Research in Securities Pricing (CRSP) and it doesn’t cast the Active Management strategy in a positive light. It’s a little dated but this five year span is still perfectly relevant. In 2005 there were 2,231 mutual funds in the “U.S. equity mutual fund universe.” In five short years 30.4% of them had vanished!!! Why did these mutual funds disappear? Underperformance. They stunk so bad that the Mutual Fund companies either had to dissolve them or quietly rolled them into a different fund.

To further the discussion and form a more complete picture let’s peel this onion one more layer. Have you ever wondered how mutual funds get started? Allow me to indulge you on a very common industry practice. Mutual Fund Companies start what are called “incubator mutual funds.” They all have different managers… with different active-management styles… and a little seed money from the mother company. As you would statistically imagine after a few years some of the funds have invariably done well and some have tanked. The ones that tanked are silently snuffed out by the Mutual Fund Company. Meanwhile, the top performing funds that have “demonstrated” returns are rolled out to the sales force with a bright shiny record to stand on. A gentleman by the name of Richard Evans conducted a study from 1996 to 2005 that concluded that for 1,048 newly created funds that were introduced- 23% of them were incubated. So in other words the Mutual Fund Companies had no clue which fund managers were going to get it right… “so let’s throw them against the wall and see who sticks.” Yikes!

I know what you’re thinking – “Why do mutual fund companies have to incubate, introduce… and later kill their funds year after year?” Active Management doesn’t work. Selection and timing of securities is emotionally appealing to many investors but in reality it’s just an expensive and ineffective way to invest.

What’s the take-away? Stick with a passive/index strategy. I know it’s fantastically alluring to think that there’s just got to be an advisor or mutual fund manager out there who can pick and time the market. All you need to do is find him… then hire him to manage your money. Smoke and mirrors… smoke and mirrors. It’s very difficult to distinguish luck from skill in the investment world. A better use of time and money is to get out of expensive cycle of picking securities or fund managers all-together. Take a giant step toward greater returns and more importantly a positive investment experience by freeing yourself from the idea of Active Management.

Allan Jaster

The Archer Consulting Group, LLC.