So when does active management beat passive investing?

by Pop on March 16, 2010

Post image for So when <em>does</em> active management beat passive investing?

If you’re visiting from the Carnival of Personal Finance at the Amateur Asset Allocator, welcome! I’m really glad you’re here. Be sure to check out my post on gold bugs and subscribe if you like what you see.

Hey, even Tyson got KO’d eventually.

In 2009, actively managed funds clobbered their indexes, according to Standard & Poor’s. You’ll have to go to the third page for the relevant stat: In 2009, 58% of active managers beat the market.

Even though S&P tried to slap a “mixed message” headline on the report, there’s no doubt that it’s going to add fuel to manager claims that we’re entering a “stock picker’s market”. In a stock picker’s market, active managers are supposedly able to deliver better results than the indexes. In a market like that of the 1990s, the story goes, you could do well by randomly buying shares of anything or by just buying the index. In a stock picker’s market you’ll need the expertise of someone who can recognize good companies at great prices.

I’ve never seen a mutual fund manager say that we weren’t in a stock picker’s market. But setting that aside, it’s still interesting to look at times when active managers bucked the trend and beat their indices. If their performance was totally random, you’d expect about 50% of them to beat the market. So a win-rate as high as 58% is worth taking a look at. But this isn’t the first time active managers as a whole outperformed. Check out the performance since 2001 (keeping in mind that this is the percentage of domestic stock funds beaten by the index):

In five of nine years, active still loses. But today, I’m interested in the years when active did win. Are there certain markets where an active manager does better?

Over long periods, active managers still underperformed.

First, let’s not get too excited about those good years. Even though active beat passive in three of the last five calendar years, 61% of active funds underperformed when all five years were taken together. That means their performance in bad years was so poor that it wiped out whatever modest advantages they had in good years.

Not looking good for active funds so far. But you could hear that stat and start down a bizarrely meta path. “If only I could invest in active funds in those good years and avoid the bad.” That is, why not just use active funds in those stock picker’s markets? In effect, you’d be actively managing a portfolio of actively managed funds.

If only it were that easy.

Active managers probably just got lucky.

They did well last year, when the market hit a bottom, and they did well in the year 2000 (the index beat 40.5% of them), when the market hit a top. The did poorly in 2002, when the market hit a bottom, and did about average in 2007, when the market hit a top. Look down the list of yearly performance, and it’s hard to find anything in common about the years when they outperformed.

That leads me to think that the outperformance of active managers last year wasn’t much more than a product of randomness. Managers like to crow about how we’re entering a “stockpicker’s market”, but I’ll be damned if I know what one of those looks like. I’ll also be damned if any of them knows what one looks like.

One bright spot: Value managers

According to S&P’s study, there was one category of fund that performed admirably. More than 60% of large-cap value funds beat their benchmark over five years. Nearly 75% beat it over three years.

Frankly, this is the opposite result I’d expect. Lots of value managers have to endure long stretches (think 10 years) of underperformance while they pick up despised stocks that sometimes still have a ways to go before hitting bottom. There’s a chance that the problem is the bogey S&P put them up against, their own S&P 500 Value fund, which I doubt is the target many fund managers or owners have their eyes on.

Sometimes I ask myself what kind of evidence it would take to convince me that investing in actively managed funds is worthwhile. One year of performance data obviously doesn’t cut it. But does ten years? Some experts argue that no performance data, no matter how robust, should be a deciding factor in picking a fund. We’re never going to have a fund manager who has a statistically sound track record—he’d have to invest for hundreds of years. So, really, no matter what fund manager you choose, you’re taking a gamble on someone who’s unproven.

Don’t declare a winner in the passive vs. active match yet. We’re still in the early rounds. Low fees, on the other hand, are something you can objectively measure. So right now, I’ll stick with the funds that win in that category.


{ 10 comments… read them below or add one }

K Smith March 16, 2010 at 8:32 pm

I agree that randomness is the most likely explanation for the superior performance of actively managed funds.

Something else to consider for those with an appetite for either active or passive funds – over the weekend the host of a popular financial radio show opined that financial statements of publicly traded companies are no longer reliable. Based on the off balance sheet Enron accounting going on at major US firms, it is foolish to buy individual stocks. The recommendation? Buy mutual funds – that way you spread your risk of off balance sheet debt over many firms.

Rob Bennett March 17, 2010 at 9:39 am

Sometimes I ask myself what kind of evidence it would take to convince me that investing in actively managed funds is worthwhile.

I am with those who say that there is no amount of data that would be enough (by itself) to persuade me to follow a particular manager. Where I take a different path from you is that I apply the same standard to Passive (Buy-and-Hold) strategies as I do to Active (Valuation-Informed) strategies. There is no amount of data that would be enough (by itself) to persuade me to follow a Passive (Buy-and-Hold) strategy either. The market as a whole (which is the manager you are following when you invest passively) is every bit as capable of getting things wildly wrong as is any particular manager.

Passive is NOT a default strategy. It is a choice along the spectrum of possibilities open to us. My view is that it is the most dangerous of all the possible choices. That view is controversial. However, I really think that it is beyond dispute that Passive (Buy-and-Hold) is a choice. There is no magic to it that does not apply to all the other choices. If data cannot supply the confidence we need to go with Active strategies, it also cannot supply the confidence we need to go with Passive strategies.

And we have got to do something with our money! Hoo boy!

The answer (I believe!) is to begin with logic, not data. When we have a model for understanding how investing works that passes the logic hurdle, then we can turn to the data to see whether the data confirms what logic tells us. I believe that it has to be done in that order. It’s not possible to feel true confidence in something that doesn’t pass the logic test.

I have a high degree of confidence in Valuation-Informed Indexing (VII) and the historical data supports VII. But I don’t follow VII primarily because the data supports it. I follow it primarily because it makes sense to me in a way that Passive (Buy-and-Hold) does not.

The bottom line here is that I believe that all investors need to spend more time thinking through the logic of Passive (Buy-and-Hold). We need to get back to the basics. What the data says really shouldn’t even be considered until you first have a model in which you have confidence because it is the model that will determine how you interpret the data. Passive Investors are (I believe!) skipping the first step.


The Biz of Life March 18, 2010 at 11:55 pm

By the time you collect enough data to prove any investing theory you’ll be dead. I’m a believer that value investing yields superior results to growth investing based upon my experience and personal observation. But it is an act of faith, and an attempt to rationalize a process that is part science and part art. Indexers and Efficient Market people try to tilt the balance to the scientific side and prove the art side is just luck or chance. They may be right, but I do believe there may be that 5% or so of managers who can be the market over the long run. The trick is finding them before everyone floods their funds with cash driving down the performance toward the mean.

UnderstatementJones March 19, 2010 at 10:04 am

I generally go with index funds, on the weak-EMH based theory that the markets are better aggregators of information than I am. The exception is a green index, where I think the market systematically makes mistaken judgments about policy odds.

What’s interesting to me is that passive investing depends on being a minority position. Imagine if everyone in the market invested in nothing but index funds. The markets would stand still. As more and more investors give up on picking stocks, more and more twenty-dollar bills are left on the ground because “someone must have picked it up already.” And at some point, managers should be able to selectively take advantage of an inefficient market and reliably beat index funds.

For the moment, though, I don’t see that as being a huge problem. A picker’s market is one in which most people don’t bother to pick, and that ain’t around right now.

YeahBut March 19, 2010 at 2:31 pm

This argument is a good one for novice investors or those who aren’t interested in doing any research and just want to keep their costs down while getting a decent return. However I always find these sweeping statements about “active managers” as if they are one monolithic force a bit misleading. I don’t care what the average active manager does or what most of them do. I just care about what the ones who run the handful of funds I own do. Doing even a minor amount of research on Morningstar or Lipper will reveal dozens of managers who over the past ten years have killed their respective indexes by large margins, from the very conservative (Oakmark Equity & Income, annualized return of over 9% in the last ten years) to the more aggressive like Fairholme or Ivy Asset Strategy. Of course they won’t be their benchmarks every single year, but if they’ve outperformed the market by significant margins 8 out of 10 years then I can afford for them to screw up once in awhile. I understand there is a degree of luck to it, but when you see a manager who has returned double digits over the past ten years which were supposedly a “lost decade” for US stocks, it makes active management very compelling. Again, it’s not for everyone, but I’m tired of being made to feel stupid for using actively managed funds when my returns net of expenses are far superior than any conceivable mix of index funds I would have used instead.

Pop March 19, 2010 at 2:59 pm

@YeahBut: Thanks for commenting. Yeah, that’s a good point. I guess I’m not convinced that a 10-year track record is a sound enough measure for me (emphasis on me) to have faith in an active manager. After all, a manager could achieve that by having one, spectacular year within those 10. Similarly, he can destroy it by having one miserable year. (See Bill Miller:

However, I don’t think you should be made to feel stupid for picking an active fund. On average, your active funds will perform, well, at about the market average. So what you’re losing by taking a risk on an active manager is the difference in expense ratios between your active manager and an index fund. Fairholme’s 1.01% ratio, for example, is costing you about 0.7% above what a large-cap index would cost. Not great, but it’s not like someone could argue you’re making a gigantic mistake.

Bender March 20, 2010 at 11:33 pm

Two words – survivor bias.

Data mining something out of morningstar is freaking meaningless.

Pop March 20, 2010 at 11:46 pm

Thanks for the comment. Actually one of the great things about the S&P study is that it accounts for survivorship bias. If you download it, you’ll see their explanation in the first few pages. And for those unsure of what we’re talking about…survivorship bias is a common mistake researchers make when studying things like mutual funds. If you focus on the funds that exist now, you miss all those funds that closed shop or merged with others. So, your study pool will naturally make actively managed mutual funds look better.

But as I said, that doesn’t seem to be a problem with the S&P study.

patrick March 22, 2010 at 1:46 am

When you refer to actively managed funds, are you referring to mutual funds which actively pick stocks in order to choose those which will out perform the market, but which are still close to 100% invested at all times?

I’m curious how that would compare to tactical active money management where the money managers have the ability to go to all cash if they so choose. The tactical managers I’ve seen have far outperformed the market indexes over the past 10 years….

If you are required to be 100% invested at all times (or fairly close) then it becomes much harder to beat the market averages, no matter how good of a stock picker you are.

The Financial Savvy College Student March 23, 2010 at 8:21 pm

I admire your approach to writing this article. I feel it is easy for us to advocate the investing method we personally utilize but you provided a very balanced analysis. I look forward to reading your blog in the future.

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