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BAM Intelligence

“Yes, There Are Good Active Funds”

So declared the headline of an article in Morningstar. A skeptic, however, might be a bit concerned that some small amount of bias may underlie this claim, since Morningstar is in the business of helping investors identify and purchase those very few “good” active funds.

But to be fair, the article does state the following facts accurately: “Because professional managers make up most of the market, on average, they can’t beat the market, on average, after they deduct their fees. So, low-cost indexing is bound to beat the typical active manager. Even the managers who manage to beat their bogies in one time period will find it darn near impossible to do so in subsequent time spans.” The emphasis is mine.

Morningstar did acknowledge investors have noticed the persistent failure of active management. In recent years, they have moved hundreds of billions of dollars out of actively managed funds.

The article’s author, Dan Culloton, even went so far as to admit, “To the extent that the cash has gone toward building balanced portfolios of cheap, broadly diversified stock and bond index funds, it has been smart money.” But Culloton then holds out the hope that active managers can outperform, and investors can possibly identify the few winners ahead of time – which is true.

The article cited Gus Sauter, Vanguard’s former chief investment officer and a veteran index fund manager. Sauter conceded that active management isn’t a hopeless cause, saying it is possible for some active managers to beat the market, although it’s so hard to pick them out prospectively that investors still should index a large portion of their assets, just in case.

First, that’s not exactly a strong endorsement of active management. Second, what else could he say? Not only did his former employer offer active funds, but he used to run one of them. Read carefully what he had to say about the issue: “Like everybody else in this industry, I have an ego large enough to believe I’m going to be one of the select few that will outperform.”

What’s hard to understand is, if, as Sauter said, indexing is so good it should make up the vast majority of your portfolio, then why shouldn’t it be right for your whole portfolio? Said another way, “hope” isn’t a strategy – at least not a prudent one.

Then the article quoted legendary investor David Swensen, who runs the Yale Endowment Fund. In Swensen’s opinion, if you can’t bring the same kind of time, expertise and resources to bear on the task of selecting managers that Yale can, then don’t bother. Just index everything. He said, “There’s almost no chance that you’re going to pick an active fund that’s going to beat the market over a 20-year period.” Again, the emphasis is mine. When was the last time you looked in the mirror and saw David Swensen staring back? And remember, the Yale Endowment doesn’t have the burden of taxes individual investors face.

Here’s what fund manager Ted Aronson of AJO Partners had to say about the burden of taxes on active managers: “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.”

One of the rules I live by is, if people with more skill and resources than I have failed to persistently succeed at an endeavor, I shouldn’t attempt it, because without their skills and resources, I’m even more likely to fail. It seems logical to believe if anyone could win the game of active management, it would be corporate pension plans. Why?
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Controlling huge sums, they have access to the best portfolio managers, including many who don’t manage retail assets. Research shows they hire only those managers with outstanding track records. Many, if not most, hire professional consultants (such as Frank Russell, SEI and Goldman Sachs) to help them perform due diligence. Plus, they pay lower fees and don’t have the same burden of taxes.

Despite these advantages, studies on the performance of pension plans have found that, while they hire managers who have generated persistent outperformance (alpha), that alpha has the nasty tendency to disappear once they come on board. What advantage over these giants do you have that can convince you that you or your financial advisor will be able to succeed where they fail? I certainly cannot think of any.

The Morningstar article concluded, “You can increase your odds of success, though by no means guarantee it, by setting very high standards for selecting actively managed funds and sticking with them.” But isn’t that exactly what the pension plans do? And yet they don’t show any evidence of being able to persistently outperform simple index benchmarks, let alone the best-designed passively managed funds.

The evidence against active management is so compelling, it led Charles Ellis to write “Winning the Loser’s Game” – a book management-guru Peter Drucker called “by far the best book on investment policy and management.”

Ellis called active management a loser’s game because, while it is possible to win, the odds of doing so are so low that it’s not prudent to even try. And like other forms of gambling, the surest way to win is not to play.

This commentary originally appeared October 29 on MutualFunds.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2015, The BAM ALLIANCE

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Larry Swedroe

Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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