The individual investor and actively-managed mutual funds

Institutional investors avoid mutual funds. Our site does not recommend actively managed mutual funds even for individual investors because of their high costs (in fact, Canadian funds are the most expensive in the world); see Our Philosophy and Actively managed funds on our site. Nothing in the report makes us change our minds.

The report cites and analyses (p.45-48) various studies yield mutual funds. Here is the overall conclusion:

Studies of mutual fund performance show no evidence of aggregate skill after fees and persistent positive manager alpha is difficult to identify. However, recent models suggest some investment in active management is rational. P. 45

The report refers to a series of studies that have looked at and quantified the annual cost for investors who seek to beat the market through actively managed funds.

Fama and French (2008) use data from 1962 to 2006 to examine evidence for skilled active management. Using their Fama-French factors and a momentum factor as a benchmark, the authors find that equity mutual funds provided negative 85 basis points per year to the investor. In short, indexation would have been better than investing with an active equity manager, on average. Before fees, Fama and French find that active management added 29 basis points per year but do not find this amount statistically significant. They also note that the cross‐sectional variation in manager performance is inconsistent with the existence of a group of over‐performers as there were fewer extreme positive performance managers than would be expected by chance. P.45

Wermers’ (2000) comprehensive study of mutual fund performance also uses stock level characteristic controls as well as factor benchmarks. The former involves constructing control portfolios that hold stocks with the same book‐to‐market ratios, size, and other firm‐level characteristics as the stocks held by the mutual funds. He finds that mutual funds outperform the S&P500 on a gross basis, but underperform on a net basis. Similarly, the average gross alpha is 0.79% per year, but the average alpha after risk controls is 1.16% per year. P.46

In his presidential address to the American Financial Association, Kenneth French (2008) goes further and computes the cost of active management to all investors – including individual investors, mutual funds, institutions, and hedge funds in the U.S. equity market. He concludes that the average investor would increase his average return by 67 basis points per year switching from active to passive management. P.46

4. Recent theory and empirical evidence suggests that some fund managers do have talent and out‐perform market benchmarks before fees. However, little of that superior ability filters through to the ultimate investors in those funds with after‐fee returns and alphas being, on average, zero or negative. P. 62

Another approach to the question of active management is to see if winning managers repeat their superior performance. Tests of performance persistence have a long history beginning with William Sharpe (1966), who found some evidence of persistence. Since then, researchers continued to find some evidence of persistence, but funds that beat the market on a risk adjusted basis consistently are hard to find. Often, performance persistence shows up in underperforming funds continuing to underperform rather than outperforming funds tending to continue their outperformance (cf. Brown and Goetzmann, 1995; Gruber, 1996; Carhart, 1997). Note that this literature does not support the conclusion that investing with winning managers will, on average, increase a mutual fund investor’s probability of beating the market on a risk‐adjusted basis. P. 47

The report tries to pull a rabbit out of the hat by referring to a study that claims that there is a statistics-based  argument for believing that it should be a role for active asset  management in the portfolio of every investor, but this study is not based on data analyzing actual results of actively managed funds,  does not quantify the role that active management should play, and poses prerequisites (e.g. having the ability to identify in advance super- performing  fund managers and to analyze their compensation package) that virtually no  individual investor could ever meet. For individual investors, it would have been better to let this rabbit sleep.

An interesting recent approach to the question of whether active management should be rejected as a strategy is to ask under what set of beliefs concerning market efficiency an investor should eschew all active management. Baks, Metrick and Wachter (2001) address this question using a Bayesian framework and their results suggest that virtually all investors – even very skeptical ones – would use at least some active management. In a related approach, Pastor and Stambaugh (2002) find that, “Investing in active mutual funds can be optimal even for investors who believe managers cannot outperform passive indexes.” These Bayesian approaches make a strong case for active investing even in mutual funds. However, the proportion of active management remains an open question. P.46

Economic profits may accrue to managers with competitive advantages in the
acquisition, analysis and trading on value relevant information. As a result, the balance between indexation and active management is a choice variable for which the optimum depends on many factors. These include beliefs about the existence and potential of manager skill, the pricing opportunities afforded within a given market, the time preferences and risk aversion of the investor, and the expertise and incentive contract of the manager. P.62

Obviously you need to do more then simply believe in the existence of super-performing managers. You actually have to identify them in advance. And if the institutions can’t do it successfully (see the following text), the chances that the individual investor can do it are much worse.

Stewart et al. (2009) use institutional manager data provided by Informa Investment Solutions from 1984 through 2006 and ask whether institutional pension plan sponsors add value through the manager selection process. In short, they ask if plan sponsor money is “smart.” The answer is no. p. 49

Conclusion

The report has difficulty in pinning down the actual and ideal the role for active management in the operations of one of the largest asset managers in the world. One of its few concrete specific recommendations is to develop internal benchmarks that reflect its particular situation and characteristics, a recommendation which relates more to passive management and is irrelevant for an individual investor.

None of the arguments given to justify a role for active management within the GPF fund apply to the individual investor. Our recommendation: add this report to the long list of reports or studies that should be read as encouraging an index approach to investing for the individual investor.