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Intercst writes:

How many is "many"?

Galeno's post stating that only about 5% of actively managed funds beat the S&P500 over a 20-year holding period matches the research I've seen. If you have any credible research that shows that a higher percentage of actively managed funds out perform, please post a link. I'd be interested in reading it.

As would I. All the research I've seen shows the vast majority of managed funds underperform the index fund over 20 years on a pretax basis. In a tax deferred account, that would hold true on an after-tax basis as well. I've never seen any data to show otherwise. Sure, there are a very few managed funds that will do better than the index fund, but trying to pick those prospectively is far harder than trying to pick a winning stock. Indeed, until someone shows some research indicating otherwise, over the long haul an index fund is virtually a no brainer.


I think Galeno's actual claim was that only 2% of actively managed funds beat the market index over 20 years, 5% over 10 years. I see these kind of claims thrown around a lot on here, so before giving my long-winded reply I'll throw back your request -- any actual citation to legitimate empirical research that buttresses this claim would be most welcomed.

The empirical research as I understand it suggests that the average mutual fund manager slightly underperforms the S&P 500. The seminal research on this was from Michael Jensen. See, e.g., "The Performance of Mutual Funds in the Period 1945-64", 1968, J of Finance; and "Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios", 1969, J of Business. Similar, more recent studies have reached similar conclusions.

These studies tend to support the semi-strong form of the efficient market hypothesis -- i.e., that available public information is perfectly and immediately impounded into market prices. Under this theory, it is essentially impossible to "beat" the market in the very long run, on a risk-adjusted basis, without private information. This doesn't mean that in a random sample of active managers over some time period, you won't have some managers beating the market. In fact you'd expect some managers to beat the market based on random chance. Indeed, if you ignored (a) transaction costs, and (b) survivorship bias in the market index, you'd expect rational managers acting in their funds' best interest to be more or less normally distributed around the market on a risk-adjusted basis – i.e., 50% of them beating the market. Of course, managers' interests aren't at all perfectly aligned with fundholders'; in reality, I think you'd expect the median manager to be below the market mean, with skewness to the upside, as managers took greater risks (with other people's money).

So, in the long run, if semi-strong efficiency perfectly holds and active funds have higher transaction costs than passive funds, it obviously makes no sense to put your money in active funds. But, there is some pretty good evidence that semi-strong efficiency doesn't perfectly hold, e.g.: small firm effects (studies showing small firms outperform large firms on a risk-adjusted basis, see, e.g., Banz, “The Relationship between Return and Market Value of Common Stocks,” 1981, J Financial Economics), the related January effect and other temporal anomalies (see, e.g., Keim, “Size Related Anomalies and Stock Return Seasonality: Further Empirical Evidence,” 1983, J. Financial Economics; Reinganum, “The Anomalous Stock Market Behavior of Small Firms in January: Empirical Tests for Tax-Loss Effects,” 1983, J. Financial Economics; French, “Stock Returns and the Weekend Effect,” 1980, J. Financial Economics), neglected firm effects (see, e.g., Arbel and Strebel, “Pay Attention to Neglected Firms,” 1983, J. Portfolio Management), market-to-book ratio effects (see., e.g., Fama and French, “The Cross Section of Expected Stock Returns,” 1992, J. Finance), and overreaction or “reversal” effects (see, e.g., Lehmann, “Fads, Martingales and Market Efficiency,” 1990, Q. J. of Economics).

Now, there may be more recent studies disputing some of these findings and more conclusively establishing semi-strong market efficiency; I don't know – if so, please share them. And these studies don't in any way overturn the semi-strong efficient market hypothesis in general; indeed, I think the hypothesis should serve as the default legal rule in judicial decision-making, and I do believe that passive index funds should be the default for most normal investors. I myself have a lot more money in passive funds than active funds.

BUT… I do think that the empirical evidence out there does suggest that it is possible to improve returns above the market, on a risk-adjusted basis, employing some contrarian strategies, especially focused on small or neglected firms. And my own observations – admittedly casual and anecdotal, not statistically significant – lead me to believe that it's possible to beat the market on a risk-adjusted basis without inside information. I know a lot of people in the hedge fund industry who work in equity funds that offset long and short positions and make pretty consistent positive returns. If you assumed that semi-strong efficiency perfectly held and they had no inside information, the expected return would be 0, since longs and shorts would offset in a zero-sum game. Now, maybe these folks are just lucky. These funds do blow up sometimes – though for equity hedge funds that's usually because one bad year puts them below a high-water mark that reduces profitability and gives the managers an incentive to return capital; and the long-run fundholders will still get some positive return (e.g., Tiger Management). Realize that sophisticated, wealthy investors pay ridiculously high fees to buy into these funds. That's not to say they're all smart and certainly not to say they should expect to beat the market return – to the contrary, they may pay for lower expected returns, given that those returns are essentially uncorrelated to their larger market holdings. But if semi-strong efficiency held, these investors would be complete idiots, since the expected return of a hedge fund that balanced longs and shorts would be 0, and they'd have a negative expected return after fees.

I remember a conversation I had with a large, successful fund manager about how he made a killing shorting a shoe/clothing company marketed to urban inner city kids, after one of the guys working at his fund had talked to urban inner city kids he volunteered with and discovered that these shoes/clothes were “last year's thing.” This information was public, but not yet assimilated into the stock price, so the fund made a lot of gains shorting the stock, which soon dropped when the next quarterly report showed a steep revenue decline.

One of my best friends runs a company that matches a network of experts to hedge fund and mutual fund managers. These funds pay a lot of money for these people's information. It's not “inside” information, but it is, like the example above, “quasi-private” in the sense that it's not necessarily impounded into the market price.

All of which is a longwinded way of saying that I don't think that semi-strong market efficiency holds to the degree that it makes sense to reject the idea of actively managed mutual funds out of hand. Indeed, Pixy you suggest as much saying it's easier to pick stocks than fund managers (a VERY questionable assertion if you accept semi-strong market efficiency; if semi-strong efficiency holds, and you lack inside information, I don't see how you beat the market in the very long run on a true risk-adjusted basis), as did galeno in saying he's “one of the 2%” who has beaten the market over the years.

What IS certain is that the higher the management fees of the fund, all else being equal, the lower the chance that an actively managed fund can beat the index. The reason that so many active funds lose out to passive indexes is precisely that so many active funds have high management fees. That's the contention of Vanguard's Jack Bogle, anyway, who argues for indexing precisely on the ground of lower fees, not semi-strong efficient markets. See,1,5766,00.html.
The thing is, not all actively managed funds are alike. They don't all have the same fee structure. If you do a sort of funds on Morningstar and take out all the actively managed funds above a certain fee threshold, then suddenly performance vs. the passive index changes (indeed, as you'd expect under semi-strong market efficiency before transaction costs). Vanguard itself has plenty of low cost managed funds; often the operating expenses are only 0.1-0.2% higher than those at the comparable Vanguard passive index fund. That's not so much, even over the long run: in 20 years, if the expected annual market index return is 11%, you get an 806% expected return, vs. 792% with an additional 0.1% fee vs. 778% with an additional 0.2% fee. That's a far cry from say an additional 2% management fee, which would lower your expected return to 560%.

The real question is whether those extra fees can enable a manager to beat the market by buying quasi-private information or analysis, as discussed above. For those active funds with additional fees in the 0.1-0.2% range, I'm willing to bet they might, at least on a pre-tax basis, at least for small cap and international holdings. (Notice I said might, not will -- I still have more money in passive index funds, and I'd advise most investors to do likewise.) For those with much higher management fees, my general bet would be no way (at least, unless what I'm buying is something that isn't really intended to beat the market but rather give a positive return uncorrelated to the market, thereby enabling me to get a higher risk-adjusted return for my total portfolio, and/or get returns not publicly available (e.g., private equity, venture capital)).

If you agree with me that active fund managers can beat the market, assuming your extra fees buy more value than you pay, then the real question remains whether it's possible to identify them with any confidence. The short answer is, I don't know for sure. There are empirical studies that show persistence of performance by mutual fund managers (e.g., Hendricks, Patel, and Zeckhouser, “Hot Hands in Mutual Funds: The Persistence of Performance,” 1991), but it's hard to have confidence in these results given inherent survivorship bias problems (see Brown, Goetzmann, Ibbotson and Ross, “Survivorship Bias in Performance Studies,” 1992). I tend to go with established funds with established managers with established records, and let the chips fall. I use these active funds to diversify my overall portfolio, stick to low fee options, concentrate them in areas where the empirical evidence against semi-strong market efficiency is highest (e.g., small cap and international), and put them in my tax deferred accounts, which was my original, central point – since active funds tend to generate more tax liability, if you hold them, they should be in your tax deferred account.

I know this is long and rambling, but I hope it's useful to somebody, and I welcome comments. I have additional thoughts on what you wrote, but since this is so long already I'll save them for a different post.
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