First, let’s start with the motivating visual, from Dilbert:
Q: What’s the difference between Dogbert and an actual fund manager?
A: The tail wagging.
I kid (sort of, and badly), but there’s a lot of truth to be had here. Active management of mutual funds seems like a really good idea- shouldn’t an investor want a bunch of supposedly smart people doing their homework about the different stocks to invest in and picking the best ones? Clearly that should yield a better outcome than just investing in an overall market index (or having a monkey pick stocks via a dartboard- see below), right. Sadly, this advantage is not realized in practice.
Take as an example an article from thestreet.com (2002) – “In the first five months of 2002, the average actively managed fund underperformed the relevant Standard & Poor’s index in seven of the nine Morningstar categories — and one of the remaining two essentially tied the index.” Well gee, that sounds less than stellar. The article continues…
Study after study has shown that index funds outperform 75% of actively managed funds over virtually any time period. But half of the remaining funds (or 12.5%) that outperform their relevant benchmark do so just as a matter of chance, according to research done by finance professor and chair of the Richard H. Driehaus Center in Behavioral Finance at Chicago’s DePaul University, Werner De Bondt. Those numbers are even more compelling since they don’t include the thousands of failed funds that have either folded or merged over the years.
(Aren’t you glad that I finally figured out to use the blockquote tag?) The article has some interesting year by year graphics, and it also points out that, even if you manage to find one of the 25% of funds that beat the market in a given year, it’s not the case that this fund is likely to be one of the ones to beat the market in upcoming years. (In other words, there is low correlation between the winners this year and the winners next year…hence the “past performance is not an indicator of future returns” warning that is on everything having to do with mutual funds.)
In case you are not convinced due to the fact that this article is from 2002, here is an article from February 2009 (NYT) that has a similar thesis and new evidence. The general mantra is that fund managers can’t (consistently or in expectation) beat the market, so investors end up doing worse on average with active management because they are paying higher overhead by way of taxes and fees.
In the book A Random Walk Down Wall Street, Princeton Professor Burton G. Malkiel theorized that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” The Wall Street Journal decided that this statement made for an awesome publicity op and decided to empirically test the statement using staff members in place of monkeys. (I think it would have been funnier if they used actual fund managers as the monkeys, or alternatively if fund managers had appropriately-labeled dart boards in their offices. I am now envisioning amazing holiday gifts for some friends of mine.) A good summary of the contest can be found here. Some highlights:
On October 7, 1998 the Journal presented the results of the 100th dartboard contest. So who won the most contests and by how much? The pros won 61 of the 100 contests versus the darts. That’s better than the 50% that would be expected in an efficient market. On the other hand, the pros losing 39% of the time to a bunch of darts certainly could be viewed as somewhat of an embarrassment for the pros. Additionally, the performance of the pros versus the Dow Jones Industrial Average was less impressive. The pros barely edged the DJIA by a margin of 51 to 49 contests. In other words, simply investing passively in the Dow, an investor would have beaten the picks of the pros in roughly half the contests (that is, without even considering transactions costs or taxes for taxable investors).
The pro’s picks look more impressive when the actual returns of their stocks are compared with the dartboard and DJIA returns. The pros average gain was 10.8% versus 4.5% for the darts and 6.8% for the DJIA.
Unfortunately for the fund managers, even the one seemingly positive result to come out of this for them doesn’t hold up to further scrutiny. Professor Bing Liang, in a paper entitled “The ‘Dartboard’ Column: The Pros, the Darts, and the Market”, concluded that the pros neither outperformed the market nor the darts. According to Liang, the pros supposed superior performance could be explained by the small sample size, the announcement effect (i.e. people investing in the stocks recommended by the experts and thus pushing up the price), and the missing dividend yields (since dividends weren’t counted in the return comparisons).
In conclusion, I now have a stunning mental visual of Dogbert with a dartboard…