Actively Managed vs Index Fund Investing

[Another Reader]

OK, folks.  Read this and have at it!

http://www.latimes.com/business/la-fi-1006-main-funds-20131006,0,409152.story

No question the bulk of actively managed funds are garbage.  The worst offenders are in 401k's, for everyone to see and to be forced to accept.  No wonder there is a flight to index funds.  However, if you do your homework and stick to the best actively managed funds, you have a decent chance of consistently beating the market, at least by a little.  And that's after fees. 

[grantmeaname]

Are you making that inference from this AF study that the author linked to, or did you link the wrong article? Because I don't see anything in the LA Times article that suggests that.

[Another Reader]

•Consider active funds in asset categories where managers historically have had a better chance of outperforming the index. In the five years that ended in June, 43% of emerging-market stock funds beat their index. Among U.S. large-stock funds, by contrast, just 23% beat their index.

Find the 43 and 23 percent.  It's just not that difficult to find the consistent performers.

Here's a growth of $10,000 chart for Oakmark, one of the better known funds that has outperformed the benchmark. 

https://www.oakmark.com/Oakmark/web/me.get?WEB.websections.show&OAKMARK_375

[grantmeaname]

It is difficult, because outperformance isn't persistent from period to period.

[Petunia 100]

Yes, it is very easy to identify actively managed funds which have outperformed.  Unfortunately, the information is useless since you cannot travel back in time, buy the fund, and benefit from the outperformance.  What you need to be able to do is identify which funds will outperform in the future and buy them now.  It also helps if you know exactly when the outperformance will stop and the inevitable reversion to the mean begins.

[Another Reader]

Oakmark looks pretty darned "persistent" to me.  There are many others out there.

I'm not against investing in indexes.  I have taxable money in indexes for tax reasons (low turnover).  However, there are active fund managers out there that have consistently beaten the indexes and that should be recognized.  People should look critically at statements about indexes performing all actively managed funds over time.  Such statements are just not accurate.

Why is reversion to the mean inevitable?  If these managers were throwing darts, sure.  But they are not.  They are not outperforming because of a statistical anomaly.  They study the businesses they buy and occasionally sell. 

Most active fund managers are worthless and the customer pays for bad performance.  The good ones are worth what you pay them.

[grantmeaname]

Oakmark looks pretty darned "persistent" to me.  There are many others out there.

And Fidelity Magellan looked pretty darned persistent too, until it wasn't. What's your point?

People should look critically at statements about indexes performing all actively managed funds over time.  Such statements are just not accurate.

That's not what anyone's saying.

[Another Reader]

The point should be obvious.  I will take my $139k to the bank and you can continue to assert passively managed funds will outperform.

[maxdriver]

Oakmark looks pretty darned "persistent" to me.  There are many others out there.

I'm not against investing in indexes.  I have taxable money in indexes for tax reasons (low turnover).  However, there are active fund managers out there that have consistently beaten the indexes and that should be recognized.  People should look critically at statements about indexes performing all actively managed funds over time.  Such statements are just not accurate.

Why is reversion to the mean inevitable?  If these managers were throwing darts, sure.  But they are not.  They are not outperforming because of a statistical anomaly.  They study the businesses they buy and occasionally sell. 

Most active fund managers are worthless and the customer pays for bad performance.  The good ones are worth what you pay them.

Please tell us about the many fund managers that are out there that outperform the indexes....? I don't mean for a 5 or 10 year period either...thanks

[Another Reader]

I think Oakmark's 22 years works.  I suggest you look through the funds from the better companies.  You will find them.  Disproving assumptions is good exercise.

And don't dismiss a 10 year performance record out of hand.  If you monitor your portfolio, you will see when fund management changes or when performance weakens.  Magellan gave a lot of warning before it went south.  I'm watching a couple of good funds at T Rowe Price that changed managers this year.  If there are major changes in their holdings and performance slips, these funds will be replaced.

The stock market is not a casino.  Businesses do not behave randomly.  Most fund management companies either aren't very good at the job or their interests are not aligned with yours.  Some are good and also customer focused.  Take advantage of that.

[maxdriver]

Nope, I won't be taking that suggested look.

The overwhelming majority do not beat the market and to me it's not worth the effort trying to identify those who might; then trying to decide when to get out.

One may have heard of Bill Miller at Legg Mason and what happened to his 5-star fund that beat the S&P for about 15 years....?

[grantmeaname]

The point should be obvious.

It's not, unless your point is that because a single fund manager has outperformed comparable indices during many of the last twenty years it necessarily follows that any mutual fund that did well in the past will continue to do so in the future. As Morningstar's analysts will attest, that's certainly not the case.

I think Oakmark's 22 years works.  I suggest you look through the funds from the better companies.  You will find them.  Disproving assumptions is good exercise.

I've heard two examples of funds that have outperformed their indices over such long periods: Oakmark and Davis New York Venture. Considering there are about ten thousand mutual funds in this country, and companies routinely shut down failing mutual funds so those ten thousand are the survivors of an even larger set, I don't think that's compelling evidence that active returns are persistent. If there were no persistence at all we would still expect some firms to make the lucky guess every period and come up with heads fifteen times. (And again, Oakmark didn't come up with all heads. VWELX has a similar stock/bond weight and is basically a closet indexer, yet it has outperformed OAKBX in 2004, 2006, 2009, 2011, and 2012 - that's five of the last ten years.)

And don't dismiss a 10 year performance record out of hand.  If you monitor your portfolio, you will see when fund management changes or when performance weakens.  Magellan gave a lot of warning before it went south.  I'm watching a couple of good funds at T Rowe Price that changed managers this year.  If there are major changes in their holdings and performance slips, these funds will be replaced.

1) At which point you will have underperformed and incurred transaction costs. 2) Slips in performance do not always come from changes in the management team or in portfolio, so guarding against those two do not make you immune to underperformance.

[KingCoin]

All the studies I've seen indicate that outperformance is not persistent. Here's a fairly recent article that links to studies showing that top performers revert to average or below average performance:
http://blog.newconstructs.com/2013/07/31/dont-bet-on-luck-active-management-underperforms/

Making claims about the value of active management based on the performance of ONE FUND is much less compelling than comprehensive studies that definitively show that betting on hot-hand funds (even funds with long running hot streaks) is a losing strategy.

I will take my $139k to the bank and you can continue to assert passively managed funds will outperform.

Ugh. This is almost exactly akin to claiming that, because my uncle won $50k playing craps, I'm going to go play craps, take my $50k to the bank, and laugh at all you craps nay-sayers with your talk of "math" and "odds" and "evidence".

It's worth noting that often these guys outperform by getting one or two big picture calls right. They're long small cap growth when small cap growth goes on a 10yr winning streak for instance. It's possible that a fund like Oakmark was long defensive stocks going into the crisis, and the stepped on the gas with high beta financials during the crisis. A well timed rotation like that would explain all of their outperformance without really requiring any particular stock picking genius. There's no reason to expect that they're going to get subsequent macro calls right. Just look at John Paulson's recent performance as a perfect example.

I'll add that it's possible that the guys at Oakmark have unlocked the secret to the stock picking game and that they'll continue to outperform for the foreseeable future. The evidence is just overwhelming that it's substantially more likely that these guys are lucky than good.

[Another Reader]

Let's put it this way.  My actively managed funds, and the funds like OAKMX that my parents bought 20 plus year ago, generally equal or outperform their indexes over time.  I look at them at least every quarter.  Over time I have trimmed the ones that fell by the wayside and added a few that developed long track records of solid performance.  I stipulate low cost index funds are far superior to most actively managed funds.  I own them in taxable accounts. 

In any given year, 20 percent of the actively managed funds typically outperform the indexes.  Over time, a much smaller percentage outperform consistently.  However, the market is comprised of businesses that do not behave in a random fashion.  Astute, principled managers can study these businesses and select the better ones and select against the poorer ones.  If I can grow my portfolio faster than the naysayers with these people, that's what I'm going to do.

OAKBX and VWELX are pretty similar in behavior although they own different things.  Today you would be in about the same place after 10 years.  They both are actively managed and both beat the benchmark indices and their peers.

[LowER]

For OAKMX, ER is 1.03.  How much are the fees?

[Another Reader]

I don't invest much in emerging markets, but the value of active management is obvious when 43 percent of actively managed emerging market funds beat the indexes.  That means picking winners and losers in these markets (probably more about spotting the losers in less regulated markets) is pretty easy.  If markets were truly random, would it be that easy?

Performance is after expenses.  Oakmark is a no-load fund company.

[ender]

This is a debate I have given up trying to have with people almost completely.

People who are proponents of active funds do not want to look at statistic after statistic and consistently make claims like, "but my actively managed fund!" or "but my stock picking strategy!" which are impossible to refute when they will not look at the wealth of studies/statistical data.

It will always be possible for some people or investors to beat the market. But over time they nearly all will not. This is what study after study shows.

I don't get it at all.

[Another Reader]

Not all studies show the same result.  And putting some individual stock picking strategy in the same category as a well run actively managed fund is insulting to the fund managers.

[KingCoin]

I don't invest much in emerging markets, but the value of active management is obvious when 43 percent of actively managed emerging market funds beat the indexes.

I'm scratching my head on this one. I think you're looking at this from an incredibly generous perspective (seeing the glass 43% full?).

If you have 1,000 stock picking monkeys try to beat the emerging market index, ~500 of them will succeed. Yet, only 430 active managers succeeded. Not only is the value of such managers not obvious, it's readily apparent that they're worse than monkeys.

Not all studies show the same result.

This is crying out for citations.

I have no axe to grind with active managers. Show me argument that doesn't rely on hand-waving on how I can make more money and I'm all ears.

[RobertBirnie]

the value of active management is obvious when 43 percent of actively managed emerging market funds beat the indexes.  That means picking winners and losers in these markets (probably more about spotting the losers in less regulated markets) is pretty easy. 

43% is pretty darn bad. I promise I could match the market, just go and buy it with an ETF, and then I'd beat 57% of active funds. Sounds like a no brainer to me.

[Petunia 100]

I don't invest much in emerging markets, but the value of active management is obvious when 43 percent of actively managed emerging market funds beat the indexes.  That means picking winners and losers in these markets (probably more about spotting the losers in less regulated markets) is pretty easy.  If markets were truly random, would it be that easy?

Performance is after expenses.  Oakmark is a no-load fund company.

If 43% beat the index, then 57% don't.  I'm not seeing how this proves that picking winners in EM is easy, or that the value of active management is obvious.  It seems to me you have just proven the opposite.

[tooqk4u22]

I really wanted to stay away from this but can't help myself as I believe that if you have the right skills and risk appetite (i.e. stones) then you can beat the market.....but only a very very very small fraction of the population can do this and it is a lot of work.

Emerging market funds need evaluation and need to be selected like stocks

[willn]

Why is reversion to the mean inevitable?  If these managers were throwing darts, sure.  But they are not.  They are not outperforming because of a statistical anomaly.  They study the businesses they buy and occasionally sell. 

And they could still be "just lucky".  Statistically someone will be, and some of the lucky will be highly skilled, just as some highly skilled will be unlucky. You have no way of knowing it was their skill, or simply coincidence.   Such is the nature of prediction.   You, will need to be skilled at picking the skilled, and lucky in picking the skilled lucky.

Doesn't mean you shouldn't try--just that perhaps you should recognize the risk is more than it may appear, so perhaps it would be better to invest a smaller percentage of net worth in this type of stuff.  Or, perhaps, take that small percentage, and invest it in even riskier, but possibly higher return stuff.  Barbell theory etc.

[KingCoin]

I think we can fairly summarize as follows:

1) The phenomenon of "skill" may or may not exist in stock management (at least as it pertains to consistently outperforming an index).
2) The phenomenon of "luck" certainly exists as dictated by randomness in the market.
3) No reliable method has been developed to separate performance due to luck vs performance due to skill.
   3a) Employing a strategy based on buying the funds of high performing managers has been proven to be a losing strategy. Past outperformance is not correlated to future outperformance.
   3b) Claims that a manager is "skilled" rely on faith and hand waving arguments rather than any testable claims. 
4) Index funds outperform actively managed funds on average.

Given (3) and (4), the only sensible investment strategy is to invest in index funds.

[MilStachian]

I STRONGLY urge everyone to watch this documentary by PBS.   http://www.pbs.org/wgbh/pages/frontline/retirement-gamble/

While some of the folks they interview are goobers (like the idiot, school-trained economist who says he didn't bother studying his 401(k) options), and they try to make big banks look like evil monstrosities, there's still a valuable lesson to be had.  If anything it will remind you that you're doing the right thing being so involved in planning your financial future.

[KingCoin]

I STRONGLY urge everyone to watch this documentary by PBS.   http://www.pbs.org/wgbh/pages/frontline/retirement-gamble/

While some of the folks they interview are goobers (like the idiot, school-trained economist who says he didn't bother studying his 401(k) options), and they try to make big banks look like evil monstrosities, there's still a valuable lesson to be had.  If anything it will remind you that you're doing the right thing being so involved in planning your financial future.

Care to summarize the major take-aways? It opened with a couple people wining about saving, and I quickly lost interest.

[Brandon Curtis]

"Kritzman measured a hypothetical stock index fund with an annualized return of 10 percent, an actively managed fund with a return of 13.5 percent and a hedge fund earning 19 percent. At the end of his calculation, he found that the index fund’s average after-expense return was 8.5 percent, compared to 8 percent for the active fund and 7.7 percent for the hedge fund.

Standard and Poor’s 2012 report comparing index funds to their actively managed counterparts draws similar conclusions. According to the study, index funds produced better returns than actively managed funds in 16 of 17 investment categories over the past five years.

That is not to say actively managed funds cannot out perform indexes. Indeed, many successfully do. But as Bogle cautioned FRONTLINE correspondent Martin Smith in The Retirement Gamble:

Returns do not persist. The good markets turn to bad markets, bad markets turn to good markets … So the system is almost rigged against human psychology that says something has done well in the past, it will do well in the future. That is not true."

Link.
Have you ever watched elementary school kids play soccer?  They all rush for the ball and follow it around the field in a crowd, what my coach used to refer to as 'amoeba soccer'.  It's exactly this part of human nature that kicks in when one particular sector or investment strategy pulls slightly ahead of the others in the short-term: investors pile on, and the magic fades.

Morningstar has an article that discusses how investors regularly shoot themselves in the feet chasing after past performance.

If you want to speculate (and that's exactly what you're doing, and paying someone else a ridiculous 1%+ expense ratio to help you do it), good luck to you—you're  going to need it.

[kyleaaa]

Why is reversion to the mean inevitable?  If these managers were throwing darts, sure.  But they are not.  They are not outperforming because of a statistical anomaly.  They study the businesses they buy and occasionally sell. 

The vast majority of the research indicates that studying the businesses they buy/sell is the same thing as throwing darts.