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There is a belief held by many investors that active mutual fund managers can beat the stock market and provide greater returns than the returns produced by simply investing in an index and getting market returns.  After all, active managers are experts in their field, right? They have intimate knowledge of the companies in which they invest.  They know all the details about the company’s prospects, cash flow, debt, etc.  They have complex algorithms that tell them what to buy and when to sell.  They spend millions of dollars on research.  Therefore, one would assume they regularly beat their respective indices, right?  Not according to the data.

 

Let’s see how the experts stack up versus the indices.  The Mid Year 2012 S&P Indices versus Active Funds (SPIVA) Scorecard shows that active managed funds underperformed their US benchmarks over 70% of the time across all asset classes for the 1 and 3 year periods ending June 30, 2012.  For the 5 year period they underperformed 67% of the time.  On the International front it is much of the same story1.

 

As the statistics show, it is difficult for even the “experts” to beat the market. There are just too many things working against then.  Active managers have a significantly higher cost of investing. According to Morningstar, the average large-cap mutual fund has an expense ratio of 0.87%2. Those are very high when you consider you can purchase similarly invested low cost index funds that have an average expense ratio 0.17%2.  Active managers are at a huge disadvantage due to their cost. To beat the market they have to take concentrated positions in fewer companies and take on more risk. The more money you pay your managers, the less money that will go in your pocket.

 

Another factor that prevents active managers from beating the market is that they are unable to consistently predict the future.  2008 brought us the Great Recession and extreme volatility.  There were few experts who saw it coming.  Every year carries with it unexpected events that make it difficult for active advisors to know what the market is going to do.  2012 was a great year by all accounts in the stock market, but there were some unexpected events.   The beginning of 2012 brought us the bankruptcy of an iconic brand, Kodak.  In the second quarter, JP Morgan Chase reported a loss in excess of $2 billion from trades by a division that was supposed to manage the risk of the business. By the 3rd quarter, that number ballooned up to an unbelievable $5.8 billion.  The fourth quarter brought us the fiscal cliff showdown that weighed on the market until a subsequent deal at the last minute.  A person can do all of the research on a company that they want, but it is still impossible to solve for the unknown: what the future holds.

 

There is much debate about what approach to investing is most appropriate for investors.  The statistics overwhelmingly show for long-term investors the best approach to investing is to use index funds and control what is controllable: costs, diversification, and getting market returns. Billionaire investor Warren Buffett stated it well: “When the dumb money realizes how dumb it is and buys an index fund, it becomes smarter than the smartest money.”

 

 

 

1.  Soe, Aye, 2012. S&P Indices Versus Active Funds Scorecard, New York, NY: Standard & Poors

 

2. Philips, Christopher B., 2012. The Case for Indexing, Valley Forge, Pa.: The Vanguard Group

April 3rd, 2013

By Josh Chittenden, CFP®

The Active Misperception

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