Does Active Management Work?

Over time, we will look at the debate between active and passive asset management.

What each term means. In general, should you actively or passively invest? Are there exceptions to the general rule?

Today I want to briefly highlight an article I read in the Financial Times. A subscription is probably necessary to access the story, but I will cover the key points below.

Active Global Equities Outperform

The Financial Times article is entitled, “Study finds active global equity funds outperform”.

Very interesting given that it is very difficult to impossible for active managers to consistently outperform market benchmarks over extended periods. There are some exceptions, yes. But, in general, I would not expect to see actively managed global equity funds outperform their passive benchmarks.

But if the Financial Times headlines that, it must be correct. Sell all your index funds and get into actively managed. Unfortunately, if you read past the headline and opening paragraph, it is not that clear cut.

Many “Studies” Desire Pre-Ordained Results

According to the study,

actively managed global equity funds outperformed the market by between 1.2 per cent and 1.4 per cent annually on average between 2002 and 2012.

I will not impugn this study and shall accept their results.

But it is worth pointing out a problem I have found with “studies” in many instances. Something you should keep in mind any time someone claims something, especially an unconventional finding.

In this study, why choose only a sample period from 2002 through 2012? Did active fund management not exist before 2002? Yes it did, in case you were wondering. Why end in 2012 for a study that is just being published now? 4 years to assess and collate?

Watch for studies that rely on things like sample size, time period, or makeup of the participants to drive the results. In general, the larger the sample size or time period the better. Or with “makeup”, consider a poll of US voters that has a sample of 85% Democrats to 15% Republicans. You may not get a representative set of responses of the US as a whole.

The same holds true for sampling investments. You always want samples that represent the overall population as best as possible.

Again, not saying there is anything intentional here, but it raises questions. Especially given that it is very difficult to consistently beat benchmarks over longer periods.

Always view “studies” with a healthy degree of skepticism.

Investor Costs Impair Performance

I am not going to hammer the findings too much as active management can outperform in gross returns. Sadly, you – the investor – never receive gross returns. For the active managers’ services, you pay an annual management fee, plus associated costs. Your return is net of fund costs and fees.

You may have also paid a sales commission when you bought the fund. That adds to your cost structure.

This study found that active management can outperform on a GROSS basis. The study does not calculate excess returns on a NET basis. That is, the actual return that you receive. When you factor in management fees that investors pay in the real non-academic world, that 1.2% outperformance significantly shrinks.

I do not know the exact shrinkage as I do not know the specific funds assessed. But it would not surprise me if the management fees and related costs eroded the excess return to zero of worse.

The article points out that “pension funds and other big investors typically pay fees of around 0.75 per cent.” Then helpfully adds, “Retail investors often pay higher fees.”

You, gentle reader, are a retail investor.

Investopedia gives a quick breakdown of typical fund expenses that lower investor returns. Investopedia estimates that, “The average equity mutual fund charges around 1.3%-1.5%. You’ll generally pay more for specialty or international funds, which require more expertise from managers.”

If that is the average equity fund, and international funds tend to cost even more, then that 1.2% excess return in an actively managed global fund disappears quickly.

Note that active management tends to result in higher administrative and transaction costs than a passive fund. Because active funds are more “active”. Also, many international funds have higher expense ratios for a variety of reasons (regulatory, lack of transparency, inefficient markets, etc.). We will cover this in time.

Realize that your net returns (i.e., your actual performance) may be materially different than gross.

Selection Bias

Another topic to delve into at a later date. But an issue with studies of this sort, so I will briefly touch on it.

The authors looked at 143 global equity funds. Now there are more than 143 actively managed global equity funds out there, so first question is how did they choose the ones they did? Did they pick the top performers, bottom performers, etc?

If you let me look back at 10 years results, I might be able to put together a portfolio of stocks with Apple, Amazon, Under Armour, SalesForce, etc. If you ask me to put together a portfolio for success in the next 10 years, I will have less certainty.

Second, and a huge issue with mutual funds, is funds that are no longer in existence. This study chose funds that were around for all 10 years of the study. That means funds that ceased to exist during that period were not included in the results. As you can imagine, the main reason for a fund ceasing to exist is due to underperformance. Weak funds lose investors (and their capital) and usually go out of business over time. By not including low performing funds in the sample, you skew results upwards.

Think back to your school days. 30 students in class. Mid-term exam, 10 students get 80%, 10 get 50%, and 10 get 20%. Overall class average is 50%. But the lower tier students all decide to cancel the class. Same class, but instead of a 50% average, now you only have 20 students who average 65%. Simply by weaker students dropping out, the overall average rises.

Same thing with funds. Never forget that when reviewing longer term performance data.

All the Media Clickbaits

The Financial Times is not TMZ or a dodgy website that lures viewers through very enticing headlines. Yet today, everyone uses headlines to attract readers.

Even staid financial newspapers or magazines are in the business of bringing people to their sites. That leads to headlines and short blurbs that may not be 100% accurate. Do not automatically assume that what you see in the first paragraph totally agrees with the actually contents. Make sure you read things in total.

These things tend to annoy me a great deal (hence the blog post). One, they tend to be incorrect or misleading. That confuses non-professional investors and leads them to make poor choices. Two, it takes me (and other financial advisors) time to correct this misleading information with clients.

Over time, and in some sort of proper order, we will get into the themes raised in this post. The active versus passive debate being the big one. But we will also take a look at fund fees and expenses and problems with reported performance data.