Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest


Active vs. Passive: The Debate Keeps Going
By Jeff Brown, August 28, 2009, NY Times


There’s a common refrain whenever the markets are in turmoil: “It’s a stock picker’s market.”

In other words, amid all the confusion, you have to pan carefully to find the nuggets. For investors who favor mutual funds over individual stocks, this view morphs into a case for actively managed funds, which employ teams of stock pickers and analysts, over passively managed indexers that simply try to mirror given market segments.

So, how are the actively managed funds doing against the indexers?

Not too well, although there’s enough room for debate to keep the active-management advocates from giving up.

A semiannual study by Standard & Poor’s finds that over the five years ended June 30, only 37.1 percent of actively managed funds made up of large-capitalization stocks beat the category’s benchmark, the S.&P. 500. Most large-cap investors would have done better with a plain old S.&P. 500 index fund.

Only 26.6 percent of managed mid-cap funds beat their index, the S.&P. 400, while 42.6 percent of managed small-cap funds beat the S.&P. 600.

The study, which looked at 3,500 managed funds, reinforces the findings of many past studies by the S.&P., other firms and academics. Over time, the average active manager simply cannot pick enough market-beating stocks to offset the high cost of running the fund. Most indexers carry expense ratios of less than 0.2 percent, while most managed stock funds charge more than 1 percent, five times as much. Indexers’ smaller fees leave more money in the account to compound, making a big difference over the years. (Among bond funds, indexers are hands-down winners, mainly because higher fees can gobble big chunks of bond funds’ modest returns.)

Still, the active-management boosters won’t cry “uncle,” falling back on a variety of arguments.

Lending some support to their view, S.&P. noted that on an “asset-weighted” basis, managed funds matched or beat their benchmarks in “most categories except mid-caps and emerging markets.” This analysis takes into account the amount of money investors have in each fund. A few large managed funds that beat the benchmarks can therefore pull up the managed-fund results, even if the average managed fund has trailed the index when assets are not taken into account.

To managed-fund advocates, this means investors are good at picking market-beating funds. But it may also mean that funds with lots of assets can afford to spend money — their investors’ money — to lure even more investors.

Marketing on the basis of recent performance can be a dirty trick, drawing investors in too late to share in the big gains. Morningstar, the market-data firm, has worked hard to get insight into this problem, trying to distinguish investor’s actual gains and losses from apparent returns indicated by changes in fund share prices — the figures typically used in marketing materials. By looking at cash flows in and out of individual funds, Morningstar has detected a widespread pattern of investors chasing past results, pouring money in after a fund has done well and taking it out after the fund falters.

The average investor therefore does much worse than the investor who buys a block of shares and hangs on through thick and thin. In one example, the investors in the Fairholme Fund, a managed fund which mainly holds large- and mid-cap value stocks, lost 1.68 percent a year over the five years ended July 31, even though the fund officially returned 8.56 percent a year based on share price and cash distributions. An investor who put $10,000 into the fund at the start of the five years would have ended up with $15,078.19. But because many investors bought high and sold low, the average investor would have seen $10,000 shrink to $9,187.75.

Investors who favor managed funds are more susceptible to this kind of self-destructive behavior because fads change fast. The whole idea of using active managers is to hitch your wagon to a hot stock-picking team, and a fund that loads up on a hot market sector — Internet stocks, for instance — can tumble when that sector falls out of favor, driving the active-management investor elsewhere.

Managed-fund advocates often point to pockets of “inefficiencies,” dim corners of the market not often visited by analysts and business journalists, where they believe stock pickers can find enough undiscovered gems to beat the benchmarks. Cited most often are funds that invest in obscure small-company stocks and those dealing with hard-to-assess foreign stocks.

Of the funds that invest in United States small-cap value stocks, about 47 percent of those using active management beat their index benchmarks over the five-year period, according to the S.&P. study. That means you have a nearly 50-50 shot at beating the indexers with a managed fund, the best odds for any managed fund category focused on American stocks.

S.&P.’s look at funds containing foreign stocks covered four very broad categories, and generally showed that only a small minority of managed funds beat the benchmarks. Among the emerging-market funds, for example, only a tad over 10 percent beat the index. This ought to be one of the areas where insightful stock picking could pay off. It may be, however, that the high cost of researching emerging-market stocks either chews into returns or discourages the in-depth research that is needed.

Breaking the foreign-stock category down further does reveal some areas where active management pays off, according to a study by FundQuest, a firm that provides market data and analysis to financial-services companies. Over various time periods, for example, 75 to 100 percent of actively managed funds holding foreign small- and mid-cap growth stocks beat the benchmarks, the best performance of the 60 categories FundQuest examined. And 50 to 75 percent of managed funds beat benchmarks in a number of categories: diversified Pacific/Asia, foreign large value, foreign small/mid value, Pacific/Asia not including Japan.

But these small pockets look like exceptions that prove the rule.

And because they would account for only a small portion of the typical investor’s portfolio, their market-beating returns would not be very valuable. For most investors, foreign stock funds could make up 10 to 40 percent of a long-term stock and bond portfolio, with the greater amount only for investors who can stomach a lot of risk. But even those investors probably should put most of their foreign-stock allocation into funds specializing in Europe and Japan, since these are the largest foreign stock markets. In those categories, the indexers win.

A final problem with the active-passive debate: It focuses too much on what offers the biggest returns rather than what provides enough return. Among the minority of active funds that do beat the indexers, many do so by only small margins. If your long-term plan calls for annual stock returns averaging 7 percent, and you think you can get that with a low-fee S.&P. 500 indexer, is it really worth a lot of trouble to shuffle your money among a sequence of managed funds you expect to return 7.5 or 8 percent? You could, of course, pick funds that have beaten the indexes by bigger margins. But why take on a lot of annoyance and risk hoping for 10 or 12 percent if 7 percent is enough?

In picking any managed fund, you can never be certain that past success was a matter of skill, not luck. And even if you are convinced it was skill, there’s always the chance the manager will lose the magic, retire, quit or die. That could force you to find a new fund, perhaps exposing you to a big tax bill when you bail out of the old one.

With an indexer on autopilot, you don’t have to worry about who’s in charge, and that can make it much easier to sleep at night.



  1. What are Jeff Brown's arguments against active fund managers?
  2. Would you conclude from this article that securities markets are informationally efficient? Why or why not?
  3. Some time back, a Goldman Sachs trader was arrested for allegedly stealing computer programs that allowed Goldman Sachs to earn billions of dollars in trading. (See article, Arrest Over Software Illuminates Wall St. Secret, NY Times, August 24, 2009). If so, there is a lot of money to be made in active trading! Is this an argument against Mr. Brown?