The Big Myth: Active Managers Shine in Volatile Markets

Over longer periods of time, most actively managed funds fail to beat their benchmark indexes.

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The vast majority of mutual funds are actively managed, which means the fund manager attempts to beat a designated benchmark. How difficult can this be? You would think the best and brightest MBAs from the top business schools in the world could easily best the returns generated by a computer that merely tracks the stocks in the index.

The data tells a far different story. Over a five year period, studies have shown that roughly two-thirds of actively managed funds fail to beat their benchmark index. Over longer periods of time, the number of outperforming actively managed funds is estimated to be as low as 5 percent.

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What if we skewed the odds more in favor of the active manager? Volatility should favor active management because it affords more opportunity for them to demonstrate their stock picking prowess. In a recent guest commentary,  Brandon Thomas, chief investment officer of Envestnet|PMC, validated this view. Mr. Thomas noted that “qualified active managers possess acute knowledge of the stocks that could outperform in shaky markets and can keep a lookout for companies with sound fundamentals that may be available at depressed valuations.”

His enthusiasm for the skill of active managers in volatile markets was not limited to stocks. In the fixed-income area, Mr. Thomas believes that “…astute active managers can see through the froth to identify undervalued segments with higher yields and very little credit risk.”

Really? Let’s take a look at the data.

JPMorgan is no fan of passive management (in which fund managers seeks only to track the returns of a designated index). It is one of the largest asset and wealth managers in the world, with assets under management of $1.3 trillion, most of it actively managed.

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JPMorgan recently studied how active managers are doing in the current market, which is characterized by extreme volatility. It looked at the performance of 2,806 funds for this year. It found that an astounding 47 percent of them underperformed their benchmarks by more than 2.5 percentage points. This was the worst track record for active managers since 1998 when 55 percent of active managers underperformed.

When active fund managers did outperform, it was not by much. Only 13 percent of the funds studied beat their indexes by more than 2.5 percentage points.

The market did its best to cooperate with active fund managers. In August, volatility was extremely high, as reflected in the record August options volume.

The author of the JPMorgan study curiously noted that this volatility caused “…a rapid deterioration of active manager performance…”

You have to wonder what happened to the “acute knowledge” attributed to “astute” active managers by Thomas.

The data indicates that, in all markets, active fund managers are likely to underperform their benchmark indexes. This applies to bull and bear markets and to markets where volatility is low or high. Investors who rely on brokers or advisors to recommend actively managed mutual funds for their portfolios suffer from cognitive dissonance or ignorance of this data. And that’s exactly how your broker likes it.

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.