By George Sisti
The theoretical benefits of active management have proven to be fables. So why are investors still paying high fees for disappointing, inconsistent and tax inefficient performance?
It’s long been my contention that the two primary components of active management — market timing and stock picking — are modern day equivalents of alchemy, the pursuit of an illusion.
Index investors believe that the stock market is «efficient.” This means that today’s stock prices represent the consensus opinion of many smart people, incorporate all known information about a company and its prospects and will instantly adjust to new information. The market’s consensus opinion isn’t a perfect pricing mechanism but it has been awfully difficult to outsmart.
Providers of active management disagree. Some would have you believe that they can find and profit from mispriced securities. Others claim to have the ability to time the market, shifting between stocks and fixed income assets to avoid market declines. An ability to time the market has been, and continues to be, significantly overstated by many self-promoting money managers.
It is difficult to predict the long-term prospects of any company in the fast-changing global economy. A company’s stock price will change as market participants respond to random and unpredictable new information. This «random walk» hypothesis was made famous by Burton Malkiel in his investment classic, A Random Walk Down Wall Street — required reading for all do-it-yourself investors. Unfortunately, most investors haven’t read the book and are unaware of the poor track record of active management.
Any stock mispricing disappears as soon as it becomes known; making stock picking a short-term strategy. Stock pickers believe that they can outsmart the collective pricing judgment of all other market participants. It’s as if the playground bully challenged everyone in school to a fight, not one at a time, but all at once. I can’t think of a better analogy to explain the disappointing track record of stock pickers and why few have created value in excess of their fees.
So why are more than 85% of mutual fund assets invested in actively managed funds? One reason might be that many investors lack financial literacy and are influenced by fund advertising or the conflicted advice of commission based financial advisers. But do financially literate investors make better investment decisions than the average investor?
A recent study, Financial Literacy and Mutual Fund Investments: Who Buys Actively Managed Funds? interviewed more than 3,000 mutual fund investors and tracked the performance of their actively managed equity funds from May 2006 through May 2008.
The authors discovered a positive relationship between financial literacy and the likelihood that an investor would be aware of, and implement an index investment strategy. However, the majority of even the most sophisticated investors invested primarily in actively managed funds. Unfortunately, the performance of the funds chosen by financially literate investors did not yield a higher risk adjusted return than those chosen by less sophisticated investors.
One question in the survey was designed to measure a respondent’s self-assessed «Better Than Average» (BTA) score:
”On average I am able to select securities which deliver superior returns compared to those securities selected by a typical investor.”
There were five multiple-choice answers ranging from «strongly disagree» to «strongly agree». Survey participants with high BTA scores tended to be affluent, have above-average financial literacy and overestimate their ability to find outperforming actively-managed funds — what the authors call the «overconfidence phenomenon»:
«Overconfidence is a possible explanation for why even highly sophisticated participants mostly select active funds … We see that investors who are financially more literate believe themselves to be better than average in their fund choices. Apparently they are not.»
There was also some evidence that sophisticated investors tend to buy funds that have recently performed well — adding recency bias and performance chasing to their overconfidence.
Financially literate investors tended to avoid mutual funds with sales loads. However, if a fund had good recent performance, they were likely to ignore high management fees even though high management fees create a greater long-term performance drag than a one-time, front-end sales load.
The Pied Piper of active management leads investors into a Twilight Zone of short-term speculation. It’s an eerie world of greed, graphs, data massaging and half-truths; where the unwary are separated from their money.
Investors would do well to follow this advice from Warren Buffett:
«Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.»
Wealth accumulation is best accomplished by owning a prudent allocation of low-cost stock index funds for the long-term. Mix in some common sense, patience, and rebalancing. And please, stay far away from the active management Twilight Zone, where alchemists pursue illusions.