If Not 2008, Then When?

Here's an article by Jane Bryant Quinn discussing the performance of Exchange-Traded Funds (ETFs) vs. actively managed mutual funds in 2008.  As readers of my book (and clients of our firm) know, we are strong advocates for passive investing whether it be through an ETF, an index mutual fund or a passively managed mutual fund from a firm like Dimensional Fund Advisors (DFA).  In contrast, most of the financial services industry is firmly entrenched in the world of active management, otherwise known as the art of stock picking and market timing.  And why not? Hefty fees are the prize for the manager who can provide superior performance (or even subpar performance as you'll see.)

But the question remains, does active management work?  Well, let's look at last year as an example. Shouldn't 2008 have been a case study for this approach to investing?  I mean, investment gurus, stock pickers and market timers should all have beaten the broad market indexes with ease by foreseeing the impending disaster and simply selecting the right stocks or market sectors, correct?  

For the past several years, numerous friends of mine in the investing community have been preaching the virtues of active management. Passive management is great when markets are going up but active management really shines in a sideways or down market they would say. We're now in "a stock picker's market" they would shout.  Oh, really?  

Here's an excerpt from Bryant Quinn's article that provides some data points:

Last year, 58 percent of actively managed funds lost more in value than the benchmark against which they measure themselves, according to Morningstar. Small-cap managers, who are supposed to be especially nimble, had a particularly bad year: Seventy-two percent of them fell behind their benchmarks.

The numbers get worse when you compare the managers' performance with the Standard & Poor's 500-stock index. Among large-cap U.S. funds, 62 percent lagged behind the S&P 500 in 2008, as did 63 percent of all U.S. diversified equity funds.

Most managed funds trail the indexes in the first phase of a recovery, too. As an example, look at what happened in the 12 months after October 2002, the bottom of the last bear market. Seventy-eight percent of U.S. managed equity funds did worse than their benchmarks. You are paying your managers to miss.

For years, studies have shown that the vast majority of active managers fail to outperform the indexes they track over longer periods of time.  High fees, excessive trading and an inability to predict the future are typically the usual suspects when it comes to underperformance.  Sure, every year a small percentage of manager's will beat the broad market indexes and invariably "hot money" will flow into these funds (after the fact I might add.)  

The problem is that there is no reliable way to predict which manager's will beat the markets in any given year. Unfortunately, past performance, while an easy sell, has been proven to be an unreliable predictor of future performance at best.  In fact, fees have been shown to be the most reliable (though not perfect) predictor of future performance.  Higher fees generally equate to lower returns.  

As Bryant Quinn's article suggests, 2008 was no different than any other year in terms of active management and supposed outperformance.  Do yourself a favor and focus on building a well diversified, properly allocated portfolio of low cost index funds.  You'll do better over time (and spend a lot less) than the vast majority of investors.