A Hollow Defense of Actively Managed Funds

Financial experts debate the merits of paying a fund manager to attempt to beat the markets.

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Actively managed funds were hit hard last week, and not only by the sharp decline in their value. The first blow came from an article in the New York Times by David Swensen, the chief investment officer at Yale University and the author of Unconventional Success: A Fundamental Approach to Personal Investment.

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Swensen advises investors to avoid actively managed funds, where the fund manager attempts to beat a designated benchmark, like the S&P 500 index. He writes, “In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets—and invest poorly.” Swensen’s advice to individual investors is to, “take control of their financial destinies, educate themselves, avoid sales pitches, and invest in a well-diversified portfolio of low-cost index funds, like those offered by Vanguard.”

Former industry analyst Henry Blodget also weighed in and pulled no punches. The title of his blog post tells you everything you need to know: The Mutual Fund Industry is a Huge Scam That Costs Investors Billions of Dollars a Year. Here’s his bottom line: “The fact is that the clients of most traditional mutual funds would be considerably better off if the fund employees just shut their firms down, re-allocated their client's money to low-cost index funds, and found other work to do.”

The data relied upon by Swenson and Blodget is irrefutable, but proponents of actively managed funds were not about to give up without a fight. There’s too much at stake.

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Larry Light, a former editor at Forbes and The Wall Street Journal, takes issue with Swensen’s diss of actively managed funds in an article in Forbes. He has an easy solution to the issues raised by Swensen and Blodget. All you have to do is “find those funds that do beat the market”. How do you do this? Light says you start with the track record of the fund, and then determine if “a fund’s fees are reasonable (the average is 1.5 percent of assets yearly), its management is solid, and its strategy is sound and nimble.” Using this methodology, Light suggests some funds he believes are likely to beat the markets.

How sound is this advice? Information about past performance of an actively managed mutual fund is meaningless. Even Light concedes that “past performance is no guarantee of future gains.” Only about 13 percent of fund managers in a given year are able to repeat their top 100 performance in the second year. Even performance over a sustained period of time is not predictive. Burton Malkiel observed in his book, A Random Walk Down Wall Street, “It does not appear that one can fashion a dependable strategy of generating excess returns based on a belief that long-run mutual fund returns are persistent.”

Sophisticated and highly paid consultants for pension plans, unions, foundations, and endowments have demonstrated no success in finding managers who could beat the markets. One study of decisions by 3,700 plan sponsors over a decade concluded that the excess returns achieved were indistinguishable from zero.

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There is no demonstrated ability to pick outperforming actively managed funds. Light knows the data and so does the securities industry. They have a vested interest in keeping it from you. Don’t be fooled.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.