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Don’t Bet on Luck: Active Management Underperforms

Wednesday, July 31st, 2013

Any investor who believes there is no need to do their own research and diligence should take a look at this report from S&P. Oh, and this one too. The first report shows that 74% of actively managed US equity funds underperformed the market over the past three years. The second report shows that less than 5% of all top-performing funds remain in the top-quartile two years later.

Figure 1: More Luck Than Skill: <1% Of Funds Maintain Out-Performance

PersistenceScorecardSource: S&P Persistence Scorecard 2013

I argued in an article recently that index investing is not a substitute for due diligence and even passive investors must make active management decisions.

S&P’s latest reports all but prove that blindly turning over your money to an active mutual fund manager is also a bad idea. Most active managers underperform the market in any given year. Those few managers that do outperform in one year are highly unlikely to repeat the feat the next. Betting on which manager gets lucky in any given year is not smart investing.

Digging deeper into the two reports mentioned above reveals just how severely active managers have been underperforming. All domestic funds have lagged the S&P Composite 1500 by 23% over the past five years. All large-cap funds have returned 52% less on average than the S&P 500 over that same time frame. Most active managers are clearly not justifying their fees.

Don’t think you can identify a winning manager based on their track record either. Investors may have thought Bill Miller was unbeatable in 2005 after his fund had outperformed the market for 15 consecutive years. Those investors received a rude awakening when Miller’s Legg Mason Value Trust (LGVAX) lost 36% over the next five and a half years while the S&P 500 gained 13%.

Consistent outperformance by actively-managed funds is almost non-existent, as seen in Figure 1. Of the 558 mutual funds in the top quartile of performers in 2009, only one remained in the top-quartile for each of the next four years.

The takeaway is: trying to pick the next manager to get hot is not investing. It’s gambling, and the odds are heavily stacked against you. There is no substitute for good due diligence.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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