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Playing With Active Money Management Is a Losing Game

By: Frank Armstrong

Conviction of a criminal offense requires proof beyond a reasonable doubt. That's a very high standard indeed. But, the case against active management meets that burden of proof. Plainly put, if you want an investment strategy to reduce returns, increase risk, cost and taxes, hire a manager to try to beat the market. Ladies and gentlemen of the jury, the evidence is overwhelming.

In building my case, let's start by examining the universe of public data on mutual fund performance. Almost everything you could want to know about mutual funds and their performance has been tabulated by Standard and Poor's, Morningstar, The Center for Research on Security Prices (CRSP) or similar organizations. It's all widely available. It's not necessary to torture the databases in order to obtain reliable, actionable, timely intelligence.

The active manager claims that through either market timing or individual security selection he can add value to your investment portfolio in excess of his costs. If active management were a viable investment strategy, it should reliably outperform a purely passive index. That's the acid test. After all, why pay a manager when you could economically purchase an entire market basket and get better performance?

Yet the record will prove that active management is a catastrophic failure to achieve that goal.

More detailed analysis reveals that many managers in the international small category had significant holdings in emerging market stocks, which is a different asset class that had stronger performance during the period. The large percentage of out-performance among international small managers may result from a large portion of them holding a different asset class and being compared to the wrong benchmark.

An even more devastating pattern emerges when we look at fixed income. Several show failure rates in excess of 90%.

I can hear the skeptics now. What about the "good" managers that beat the averages? Let's stipulate that somebody always beats the averages, just like somebody always wins the lottery. But your chances of picking that manager in advance are dismally small. What would you use to distinguish skill and cunning? Past performance? Please! While it's possible to run up quite a string, that chances of a star manager repeating are somewhat less than average.