Wednesday, May 5, 2010

The Failure of Active Management

Over the years we have encountered many people who question our thoughts on the "failure of active management". Some reply with, "Well, how come Wall St. exists?" or "So, you are telling me Wall St. has it all wrong?". In which we reply with a resounding "Yes!". At Arianna Capital we hold the believe that stock picking and timing the markets does not bode well for most investors. Rather, suggesting that the average investor would fare better with a simple index fund, taking advantage of market returns preventing one from making emotional mistakes such as stock picking and timing the market.

Thankfully, there exists an institution to keep "score" on how these active funds perform relative to a simple index. "The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds." An apples-to-apples comparison of active vs passive management. Let's check out the results:

Over the last five years, the S&P 500 has outperformed 60.8% of actively managed large-cap U.S. equity funds; the S&P MidCap 400 has outperformed 77.2% of mid-cap funds; and the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.

The five-year data results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.

On average, academics tell us that roughly 75% of actively managed funds will under-perform relative to their benchmark. Looks as if the the SPIVA scorecard bolsters this statistic. If the professional money managers who spend night and day trying to outsmart the millions of market participants cannot seem to consistently accomplish their goal, which is to provide value ontop of the benchmark, what makes you think you can or your broker/advisor at Morgan Stanley, Merrill Lynch, UBS, or Citi/SmithBarney can? If that's not enough to convince you:

The turmoil of the past five years saw 29% of domestic equity funds, 21% of international equity funds, and 10% of fixed income funds merge or liquidate.

This statistic tells us that funds managed by professionals either liquidated or merged due to poor results. Why else would they merge or liquidate? To conceal the failure of active management.

Don't fall into Wall Street's gimmicks, just look at the numbers. Next time you talk to a salesman at Edward Jones, Merrill Lynch, or Raymond James show him/her the SPIVA scorecard and ask him how he/she can provide value. He/she will probably tell you that they can help you stay away from these under-performing funds or identify the "better" ones. Ask them how. If they have an answer, you know they are a charlatan or mountebank.

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