Wednesday, May 02, 2007

Observations on Actively-Managed vs. Passive Mutual Funds

Last Wednesday, Eleanor Laise of the Wall Street Journal wrote an interesting piece in the Money & Investing section concerning actively managed funds.

Typically, actively-managed funds are downplayed by many commentators, because the likelihood of any one fund manager consistently outperforming the market for many years is small. Investors frequently end up chasing last year's hot fund, and good returns, only to, in effect, 'buy high' and 'sell low,' only with funds, rather than individual equities.

Still, as Ms. Laise writes, while the average of actively managed funds may underperform the market, there are a few stellar managed funds in virtually any category.

The article provides some research data, mostly on small-cap funds, suggesting that, at best, perhaps a little more than one in three managers will beat style-specific indices.

However, at the end of her column, Ms. Laise suggests the following,

"Instead of picking active managers based on sector, you should look for low costs and a long-term consistent track record. Since fund expenses reduce returns, lower fees mean managers must clear a smaller hurdle to beat the index."

In effect, she is saying that, while most fund managers cannot beat the market average over time, it's worth finding the few that can, and investing in them. The key is to look for consistency, rather than specific style or sector descriptors.

From a theoretical viewpoint, what Ms. Laise appears to be contending is that, although the probabilities of the average active fund manager beating the index over time is small, there do exist managers who have done this, and their existence means it can be worthwhile to identify and use such managers. So, rather than throw all active managers out and, instead, resign yourself to choosing passive index and sector funds, you can and should find managers who have consistently outperformed the market over many years, and invest with them, not letting the averages blind you to the existence of a few significantly better-performing managers.

Ironically, I would normally agree with the passive fund allocation advice, too. My own equity strategy consistently outperforms the S&P, but I wouldn't invest in most other actively-managed funds, were I not already actively managing equities. Since I already have access to my own strategy, which fits Ms. Laise's description, I'm content to invest in my own, and don't have to go looking for the other few managers who can consistently outperform the S&P500 over time.

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