Investing 101: Why Active Management Doesn’t Work

The following is an excerpt from our ebook, “A Minimalist’s Guide to Financial Markets,” which you can download by clicking here.

By understanding the connection between risk and return, you can put together a passively managed investment portfolio built around your goals that allows the market to work for you. Unfortunately, much of the finance industry is built around trying to beat the market through active management.

It would be one thing if this was just a question of the level and types of risk you want to take, but it’s not. Active management only works in short bursts of blind luck. It is all but impossible to consistently beat the market, and it’s even harder to identify someone who will be able to do so in the future.

Three Reasons Active Management Doesn’t Work

1) It’s impossible to predict a successful active fund manager early enough for it to actually count. There’s no way to identify a fund manager’s propensity early enough for it to do you any good. A manager’s historical returns might seem too good to chalk up to pure luck, and you might be somewhat right, but a manager’s future success rate is impossible to predict. You would have just as much luck standing outside the nursery at a hospital and picking which baby will be the best fund manager in 40 years.

2) The higher cost of active management tends to cancel out higher returns. Active managers try to beat their benchmarks and get you higher returns, but all that extra trading comes at a higher cost. The manager’s fees on top of the costs of trading eat into whatever returns are generated. While this is true of all funds, active managers tend to charge more, as they are doing more stuff (to use a technical term), and they think they are “adding value” with all of their activity. In reality, that added value often costs more than its worth.

3) Active managers can’t seem to beat the market over different time periods. If certain managers were able to beat the market by skill and not luck, you would expect them to continue to use that skill to keep beating the market. This does not seem to be the case.

In fact, Dimensional Fund Advisors did a study a couple years back that examined how funds performed over time. The study took all US equity funds that survived certain time periods and checked to see which ones beat their stated benchmark. They then looked at the subsequent three-year period for all of the funds that had previously beaten their benchmarks.

Why Active Management Doesn't Work

If active managers could consistently beat the market, we would expect to see a significant increase in the percent of managers who beat their benchmark in the subsequent period. Since these managers already won in the initial periods, they would be more likely to win again, right? Didn’t they already demonstrate their skill?

Well, we did see a slight increase in the percent of funds that beat their benchmark in the subsequent period, but a lot of that can likely be attributed to dropping the truly atrocious funds that charge insanely high fees (since they likely lost to their benchmarks), as well as passively managed funds that weren’t trying to beat the benchmarks.

If these managers could truly beat the benchmark consistently, at least in aggregate, we could expect to see the numbers for the subsequent period (again the managers who beat their benchmarks during the first period) well north of 50%. Instead, all of the numbers were south of 40%

This study highlights the randomness of which funds will beat their benchmarks over a given period. Just because a manager got lucky and beat their benchmark once, doesn’t mean they can do it again.

So what should you do instead?

What You Should Do vs. What Most of the Financial Industry Does

You should focus on building a portfolio that you can use to meet your goals with the right level of risk and return.

To do this, you need a passive manager.

Passive managers harvest market returns. Passive managers don’t seek to beat the market, they know how to use the market.

In baseball terms, an active manager is trying to hit a home run every time he steps up to the plate. Striking out is much more common than hitting a home run. A passive manager, on the other hand, may not necessarily hit any home runs, but he’s consistently getting on base.

Once you begin working with a passive manager, it’s time to ask yourself an important question: Why am I investing?

Click here to download the rest of the ebook “A Minimalist’s Guide to Understanding Financial Markets.”


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