More Evidence On The Failure Of Active Investing

From an article in the 12/3/2009 Wall Street Journal on a study done by two of the world's smartest academics in field of investing:

It's impossible to tell whether actively managed funds that beat the market do so out of luck or skill, according to a new study by the professors who've championed passive/index investing for years.

The claim means that investors can't know for sure how good their active manager is, say the professors, Eugene Fama and Kenneth French. The latest Fama-French study is another piece of ammunition to support their view that most active managers can't consistently beat [passively managed] funds, which track the market. Underpinning that is the efficient-market hypothesis, developed by Mr. Fama in the 1960s, that states that assets are appropriately priced since the market has all available information.

Mr. Fama and Mr. French, professor of finance at Dartmouth College's Tuck School of Business, ran 10,000 simulations of what investors could expect from actively managed funds.
This was based on data for 3,156 stock funds from January 1984 to September 2006. They found that outside the top 3% of funds, active management lags behind results that would be delivered due simply to chance.

The study, "Luck Versus Skill in the Cross Section of Mutual Fund Returns," included mutual funds that were liquidated and any fund launched before September 2001 that reached more than $5 million in assets. (Find a copy of the report at the Social Science Research Network.)

"The simulations tell us that for the vast majority of actively managed funds, true [abnormal expected return] is probably negative; that is, the fund managers do not have enough skill to produce risk-adjusted expected returns that cover their costs," wrote the professors.

The fact that some funds in the professors' study beat the simulations does suggest that by picking the right funds investors can consistently outperform the market. But there's just one problem, according to the professors: The "good funds are indistinguishable from the lucky/bad funds that land in the top percentiles."

Given this evidence, why do most investment advisors continue to use actively managed funds? I covered this in an earlier blog (http://streffblog.blogspot.com/2009/10/simple-yet-inevitable-wealth-creation.html), but in short, it's because that's how they get more of your money.

MORAL: Only use advisors who believe in the passive/index approach.