Our clients often ask us about market efficiency, or the idea that current market conditions already reflect all available information. These questions aren’t exactly a surprise, given that the debate over market efficiency -- and its kissing cousin, the debate over active vs. passive investing approaches -- has been raging in the financial world for decades.
But while the market efficiency question may never be settled to everyone’s satisfaction, one thing is crystal clear: As evidenced by aggregated historical returns,
active management does not pay for itself. In fact, many active managers and investment professionals actually fail miserably – and here’s why.
Why Many Investment Professionals Suffer from Failure to Perform
According to the efficient markets hypothesis – which posits that stocks are always priced correctly, as they already incorporate and reflect all appropriate, relevant and available information – it’s impossible for an active-approach investment firm to (consistently) “beat the market” over the long term, except in cases of chance. Those who don’t hold with this theory – i.e., active managers – continue to test this hypothesis on a daily basis by picking stocks and timing the market.
Unfortunately for investors, an overwhelming body of empirical evidence reflects that active management suffers from higher costs (due to poor selection, high turnover, poor timing, etc.) - but provide little to no excess return.
Consider the following chart, which illustrates the percentage of actively managed, public equity funds that failed to outperform their respective market benchmarks in every major fund category from December 2008 to December 2012. Oh, and most also failed at beating their respective benchmarks as a group. If you’re shocked, don’t be… research indicates that as a group, active managers underperform the market at a rate that’s equivalent to their average expenses and fees. In other words, the active management approach doesn’t benefit your portfolio.
As in most cases, there are exceptions...kind of. In this case, the lone outlier is the “international small fund manager;” only 21% of this group failed to beat the S&P Developed ex-US Small Cap index benchmark. However, detailed analysis reveals that many managers in this category had significant holdings in emerging market stocks -- a different asset class that experienced stronger performance during the period -- and that renders the comparison benchmark irrelevant. In other words, this group’s outperformance isn’t exactly outperformance at all.
In fact, when this group’s average return is compared to an appropriate benchmark – the MSCI All Country World ex-USA Small Cap Index, which includes emerging markets -- the rate of underperformance rises to over 60%, a rate that’s par for the course with other equity fund categories.
Effective Wealth Advisors Avoid the Active Approach
Research by Eugene Fama – Nobel-winning economist -- and other financial academics also indicates that bond markets are efficient and that interest rates and bond prices do not move predictably, from short-term government instruments to long-term corporate bonds.
The following chart underlies the formidable challenge faced by active bond managers and illustrates why the effective wealth advisor avoids the active approach.
As you can see, each category of percentage of active fixed income funds failed to beat their respective market benchmark for the five-year period ending December 2012. What’s more, all categories had at least a 40% failure rate – again, not impressive.
This example isn’t unique – in fact, it’s consistent with a vast body of financial theory and research that brings us to a logical conclusion: Active managers cannot outperform the market as a group, particularly after accounting for management fees, trading costs, and other expenses.