Old Myths Die Hard

It seems that even when an article on investing in the press gets it partially right, they get some things very wrong. And old myths die hard. An example is a May 12 article in the NYT entitled: In Investing Passive Beats Active.

The article reviews the most recent data which to any reader of this blog is not at all surprising:

THEY say you get what you pay for, but mutual fund investors often get less. Actively managed stock portfolios find it hard to achieve the returns of low-cost index-tracking funds, and that was especially true last year.

In 2003, when the bull market began, 61 percent of actively managed funds specializing in American stocks beat the return of the Standard & Poor’s 500-stock index, according to the research firm Morningstar. The following two years produced similar results, but in 2006 the figure plunged to 32 percent.

Greater volatility and a leveling off in the relative performance of shares of smaller companies, which many managers favor and which showed far more strength early in the bull market, accounts for some of the sharp falloff. But there are enough other factors for some analysts and financial planners to conclude that last year was the rule, not the exception.

They warn that underperformance by active managers may continue in the next market cycle and may be even more pronounced. The inherent disadvantages of active management — mainly higher costs — as well as changes occurring in the financial-services industry almost guarantee it, they say.

Unfortunately, the article goes on to perpetuate one of the major myths pushed by the actively managed mutual fund industry and their apologists (like,for example, those folks at Morningstar). That myth is the one that in certain “corners” of the market there is a better chance for actively managed funds to outperform index funds:

For an actively managed fund to beat an index tracker over the long run, the manager’s decisions have to add more to returns than is eaten away by the extra expense. It is possible, but long-term returns suggest that it is not probable. “In any one-year stretch anything can happen, but generally index funds have fared fairly well,” said Sonya Morris, a fund analyst at Morningstar. “Over the long haul, they’re pretty hard for active managers to beat.”

The ones who are thought to have the best shot focus on comparatively obscure niches like smaller companies and emerging markets, but those areas are less under-researched than they used to be. That makes it harder for managers to find potential big winners that have escaped the notice of their peers.

“It’s possible for markets to become more efficient over time,” Ms. Morris said. She added that “it’s also possible to find talented managers in any corner of the market who are not overburdened by high expense ratios and have a proven ability to beat benchmarks over time.”

Examples she offered include two small-cap funds, Master Select Smaller Companies and Champlain Small Company, and three focusing on emerging economies: American Funds New World, Oppenheimer Developing Markets and T. Rowe Price Emerging Market Stock."

Not surprisingly a quick check of the active funds mentioned in the article by the Morningstar analyst shows emphatically that her assertion is nonsense. In fact the long term indexing strategy employed by DFA funds in which it establishes indexed portfolios based on value and market capitalization works even better in these “corners” of the market than it does in the large cap US or total US market equity sectors.

	ytd	3yr	5 yr
small cap active recommended funds
masters' select small cos	9.4%	13.0%	n/a
champlain small company	8.4%
DFA Index Fund
DFA Small Cap	5.6%	15.7%	13.5%
DFA Small Value	7.2%	20.3%	17.5%
emerging markets active recommended funds
t rowe emerging	8.9%	38.4%	27.1%
oppenheimer emerg	10.1%	40.0%	29.8%
amer funds new world	10.7%	30.8%	21.9%
dfa index funds:
dfa emerging mkts index	15.4%	38.6%	27.3%
dfa emerging mkts small index	19.9%	40.7%	31.6%
dfa emerging mkts value index	20.9%	46.8%	35.2%

The article closed with this sage advice from a very well known and oft quoted financial advisor

“We’re big believers in indexing,” he said. “Even really good managers, whom you would think could beat an index, can’t beat it because of factors out of their control. And even when you have a manager that has beaten the index, is he going to continue to beat it?”

But as compelling as the argument for indexing may be, Mr. Evensky accepts that many investors will fail to heed it.

“People are going to continue to look for something that’s going to do a lot better,” he said. “But if it ain’t out there, it ain’t out there.”

Excellent advice, but we do find it a little surprising coming from financial adviser Harold Evensky who we cited a few days ago as using actively managed bond funds for the fixed income portion of his clients portfolios.