Two More Cases Against Active Management

by on May 29, 2009

Earlier this week, I posted an article summarizing two well-respected and well-known (at least within the investor community) studies that have, on the whole, repudiated the benefits of active management as it relates to over / under weighting asset classes and selecting individual securities. These studies (the first conducted by Brinson, Hood, and Beebower and the second conducted by Ibbotson and Kaplan) indicated that nearly 100% of portfolio returns are attributable to their policy benchmarks. In case these arguments weren’t convincing, here are two more pieces that will hopefully persuade you active management is for the birds.

False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas

In this 2005 paper, Barras, Scaillet, and Wermers develop a technique that controls for “false discoveries,” or mutual funds that exhibit significant alphas due to pure luck. This approach separates funds into three categories:

  • Unskilled: Generate a true alpha of less than zero
  • Zero Alpha: Managers have some stockpicking and asset allocation abilities, but any alpha is substantially offset by manager fees.
  • Skilled Funds: Manager is able to consistently generate positive alpha through superior stockpicking abilities.

Barras et al. analyzed monthly returns exhibited by some 2,000+ actively-managed U.S., open-end, domestic equity mutual funds between 1975 and 2006. Beginning with an analysis of the long-term performance of these funds, this study indicated that:

  • 75.4% of funds are zero-alpha funds, with managers excess returns over their benchmark being eliminated by fees and expenses
  • 24.0% of funds are unskilled, displaying an alpha of less than zero
  • 0.6% of funds exhibited a true positive alpha

These results paint a rather dismal picture for mutual fund managers. Besides the evidence that less than 1% of managers is able to generate a true alpha, the fact that nearly a quarter of mutual fund manager generated negative alphas over the long term is quite concerning. As the authors note, these unskilled funds underperformed for long periods of time, indicating that investors had ample time to evaluate and identify them as poor performers.

Dilution of Talent

Another interesting fact from this study relates to changes in the composition of mutual fund manager skills over time. According to the results of the study, the proportion of skilled funds decreased from 14.4% in 1990 to just 0.6% in 2006. Part of the explanation is likely attributable to the dilution of talent in the fund manager pool as the mutual fund industry expanded. As the number of funds has increased dramatically, skilled managers have remained exceptionally rare, resulting in the current sad state for mutual fund managers.

A Little Common Sense

The authors of the three studies I’ve attempted to summarize have completed a tremendous amount of work to quantify some of the major issues with actively-managed mutual funds. But as is often the case, sometimes the simplest explanation is the best. This logical analysis in the Wall Street Journal lays out the simple case for ETFs over actively-managed mutual funds in terms all investors can understand:

 “If you’ve got 100 managers all playing in the same sandbox, the index fund has to be in the top half because it has less expenses,” [financial adviser Harold] Evensky [of Evensky & Katz in Coral Gables, Fla.] said. “And since the active managers in the top half don’t stay there all the time, the index over time gradually moves up. [...] If I can be guaranteed funds that are always in the top half, that’s pretty good,” he added, “as opposed to trying to pick one that’s going to be on top but may also end up on the bottom.”

OK, so this last article isn’t as scholarly and statistically intensive as the previous three, but its simplicity is compelling. I think it summarizes the solid analytical studies I’ve compiled quite nicely. With fewer expenses and lower volatility (relative to the benchmark) ETFs are essentially guaranteed a place in the top half of all funds every year.