Thursday, January 28, 2010

Active Management Fails Again

Every six months, S&P publishes the S&P Persistence Scorecard, the purpose of which is to measure whether mutual funds managers are able to consistently outperform their peers. As you may guess, the results are not very good for active managers. According to the S&P study, "very few funds manage to consistently repeat top-half and top-quartile performance." In other words, fund managers who are better than average this year will likely be worse than average next year.

This is why we believe so strongly in passive management, which is all about lowering investment costs. Why pay high fees to active managers when they are not able to consistently achieve superior investment returns? We think the better approach is to keep costs down and to keep our actual returns as close as possible to the asset class in which we are investing. This means that we will be giving up the chance of having higher returns then our benchmark, but we are also eliminating the chance of having lower returns.

Lowering investment costs is why we are such big fans of Dimensional Fund Advisors (DFA), because they are so focused on lowering costs throughout the investment process. DFA has just redesigned their public website, and I urge you to give it a look if you haven't done so recently. There is lots of good information on how DFA adds value, like this explanation of "portfolio engineering".

One final thought on active vs. passive management. Last year, Professors Eugene Fama and Ken French did an academic study looking at luck vs. skill in mutual fund management. I have seen Professor French lecture on this topic, and he says that when statistically analyzing mutual fund returns, the results of active managers "look a lot like luck." Which leads me to the conclusion, why pay for luck?