Actively Mismanaged Funds

“Active managers can and often do outperform for short bursts of time. But once you extend the time horizon, the probability of that outperformance continuing significantly diminishes.” – Srikant Dash, Standard & Poor’s.

A previous post sought to debunk the notion that anyone can consistently outperform the market by superior stock selection and/or stock trading, better known as active management. It’s worth continuing an examination of this approach, because so many investors, through their investment advisers, are essentially chasing a chimera. They are trying to beat everyone else by choosing mutual funds that have done well. This approach has been shown, time after time, to fail.

I concluded with this statement: “It would be wonderful if we could find really good stock pickers, the ones who consistently beat the average, but that is impossible.”

Actively Mismanaged Funds by Scott Woolley in the April 13, 2009 Forbes Magazine reinforces my conclusion.

Here are the relevant quotes:

For years William Miller’s name appeared atop lists of the world’s most successful stock pickers. His Legg Mason Value Trust outperformed the S&P 500 every single year for a decade and a half through 2005, an astonishing streak regularly cited as evidence that a smart fund manager can consistently beat the market. Customers flocked to this hot hand. Assets in the fund climbed to $12 billion, representing $200 million a year in management fees for Legg Mason. (Emphasis added.)

That’s when the gravy train came screeching to a halt. Value Trust’s 6% gain in 2006 was only half as good as the market’s. The fund has lost money ever since, including a 6.7% decline in 2007, 55% in 2008 and 20% through February of 2009. Each of those numbers was worse than the broader market’s return.

Another way to look at Value Trust: Investors paid Miller and his underlings $2 billion in management fees to destroy wealth.

Value Trust is an exceptional case of outsize gains followed by outsize losses, but the phenomenon of active managers creating wealth only for themselves is no fluke. What makes this especially searing to investors these days is the implication by many active funds that they’re worth a premium because they’ll rescue you from nasty bear markets while “dumb” index funds abandon you to a mauling.

The facts indicate otherwise. Last year, during the worst stock market drubbing since 1931, the average active stock fund lost 40.5%, versus a 37% loss for the market-tracking Vanguard S&P 500 Index, according to Morningstar. Stretch out the time frame and active management looks no better. According to Standard & Poor’s, 69% of actively run large-company funds, 76% of funds buying midsize companies and 79% of funds buying small companies underperformed their indexes in the five years through last June.

Especially humiliating lately is the performance of the largest funds, including Fidelity Magellan, in Peter Lynch’s day the grand master of actively managed vehicles. The fund lost 52% in the past year.

While Magellan has been a disappointment to investors, it has done very well for its manager, Fidelity Investments (in which the family of billionaire Edward Johnson owns a large stake). The fund’s 0.73% annual expense ratio on $41 billion in average assets added up to $295 million in fees last year. Investors could have stuck their money in Fidelity’s Spartan 500 Index at one-seventh the cost and earned more over the past one-, three-, five- and ten-year periods.

Humans, …are hardwired optimists. To our detriment as investors, we tend to overestimate our ability to pick winning stocks and stock pickers, like Bill Miller. (Emphasis added.)

The other problem is that funds are often sold rather than bought. The sellers are in it for commissions. Those are easiest to skim off actively managed funds that charge fat fees in exchange for the prospect (but not the probability) of knocking out the lights or the protection offered by “professional management” in troubled times.

Franklin Templeton’s ads boast that its flagship Growth Target Fund has “weathered the ups and downs of the market for over 50 years.” That included some rough sailing in 2008, when Growth Target, a supposedly conservative mix of stocks and bonds, lost 31% of its value and lagged its index by six percentage points, according to Morningstar.

American Century enlisted pedaler Lance Armstrong to evoke his successful battle against cancer as a template to “provide for a secure financial future.” Ultra, American Century’s largest fund, lost 41.7% last year, lagging the S&P 500.

Investors are learning

The crash is making investors rethink their faith in funds that try to beat the market. Last year they yanked out $222 billion while adding $18 billion to their index holdings, according to Lipper. That left $3.2 trillion with active managers at year’s end, compared with $672 billion in passive mutual funds and exchange-traded funds.

That shift from actively managed funds to passively managed mutual funds and exchange-traded funds is definitely a move in the right direction.