Why Active Equity Management Stinks

The majority of funds run by active managers fail to outperform their relative benchmark.

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According to a 2009 study by State Street Global Advisors, more than 70 percent of large-cap blend funds run by a portfolio manager failed to outperform their relative benchmark. Wow.

Want more? How about this, from the same study: In 2004, only 28.8 percent large-cap blend managers beat their benchmark. Tracking those successful managers out for five years to 2009 shows that only 0.1 percent of them still beat their benchmark.

That means for every 1,000 managers in this category, only one would have beaten their respective index over that five-year period. Is double wow an actual expression? If not, I'm claiming it.

Just because there is a low probability that you will be able to select a manager who consistently beats the fund's benchmark doesn't mean you should avoid investing with that manager. It just means that you need to pay attention to how much the manager charges for services and how much risk he or she takes with the portfolio.

So why pay a premium for a fund that does not make up for the extra cost and may be more volatile than simply buying a hum-drum index fund?

[See Improve Your Understanding of Passive and Active Investing.]

Maybe you or your advisor has a strategy to select managers that may outperform the benchmark in the upcoming year or so. Fine. The downside is that you or they may be wrong. However, it's not a bad idea try to select, for example, managers of large-blend funds when your investment strategy or asset allocation plan calls for that specific sort of investment. A properly diversified portfolio, even with less-than-stellar performers, will do more for your returns than finding one great manager.

Investors and, frankly, advisors, go nuts over selecting the best managers. There is an entire industry devoted to producing and selling research to aid in the selection of these managers.

As I've written numerous times in the past, all investment strategies should be the product of a complete and comprehensive financial plan. That's the big picture.

In reality, most investors don't put enough time into selecting the proper allocations to the different size and style managers (i.e. large-cap blend, small-cap value, mid-cap growth), especially since it's so difficult to pick a manager who can outperform a benchmark.

Instead, why not put time and effort into things you can control, like identifying your financial goals and objectives, along with the necessary rate of return to meet those goals? By doing this, you will inherently control the level of risk in your portfolio as well. See one of my previous blogs for more on this.

Call it "actively managing passive investments." Rather than using active managers, it's possible to use passively managed, low-cost, exchange-traded funds to track particular indices. With a mix of these funds, you or your advisor can spend time deciding which sizes and styles should be over- and under-weighted depending on the market.

For instance, an advisor can spend time researching economic indicators to get a sense of where we are in the current business cycle. From there, a determination can be made about which sizes, styles, or sectors are the most appropriate to be invested in. ETFs can be purchased to help gain the exposure to the identified indices and their associated performance.

The benefit may be that an investor or advisor can succeed by simply managing these passive investments. Since the probability is low that a manager can outperform the fund's benchmark, spend the time actively researching the indices and their place in the business cycle, and let the power of passive investing take over from there.

David B. Armstrong CFA, is a Managing Director and co-founder of Monument Wealth Management in Alexandria VA, a full service financial planning and wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. David has been named one of America's Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 & 2010 based on asset under management) and has been interviewed by several national media sources for the past several years. David and Monument Wealth Management can be followed on their blog at "Off The Wall", their Twitter account @MonumentWealth, and on their Facebook page. Member FINRA/SIPC.

*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results.

An investment in Exchange Traded Funds (ETFs), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. Additional risks should be considered such as not being diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts and Index tracking error.

Securities and financial planning offered through LPL Financial, Member FINRA/SIPC