More Bad News for Mutual Funds
Jan 25th, 2007 | Filed under: Investment Management Fees“Improved Study Finds Index Management Usually Outperforms Active Management”
By: Millicent Holmes, Brownson, Rehmus & Foxworth Inc.
Published: Journal of Financial Planning, January 2007
The debate over whether hedge funds produce any alpha is essentially the same as the age-old debate between active and passive management. This recent piece of research weights in on the state of actively managed mutual funds and it doesn’t look pretty. According to the study, active managers add value (i.e. beat their benchmarks) in US mid-cap value, US small-cap blend and international small & mid-cap blend classes only. On average, active managers in all other asset classes under performed their comparable index funds.
As usual, market efficiency seems to be the culprit:
“Over the years, we have observed that financial markets have become progressively more efficient. This increased efficiency can potentially explain the above-noted pattern of improvement in the near term performance of index management relative to active management in the Mid-cap, Small-Cap, and International asset classes.”
This might explain why mutual funds have become closest indexers (as this study suggests). Perhaps they acknowledge this phenomenon and have quietly thrown in the towel on active management. If so, they haven’t yet thrown in the towel on active management fees, however.
But all is not lost for active managers. The study also finds that active management performed relatively better during the bear market of 2000-2002. Says the study:
“…while the S&P Small Cap 600 Value Index outperformed 80 percent of the active small-cap value managers over the longer ten-year period, this index outperformed only 28 percent of the active managers during the bear market from 2000 to 2002.”
This would imply some sort of asymmetry – what author Alexander Ineichen would call a “smile” (in reference to the aim of creating convexity in the relationship between index returns and fund returns). And if active managers (like hedge fund managers) are in the business of providing option-like returns, then we wonder what the fair cost is of this down-side protection (at least, according to option pricing theory). Have active mutual fund investors essentially sacrificed too much upside for this downside mitigation? This possibility would find support in prospect theory (which essentially states that people hate losing more than they like winning).
But in the end, the study suggests that actively managed funds simply under perform less in down markets – they don’t actually beat the index. So the author of this article recommends that financial planners sell their active funds and buy index funds.
“…the average expense ratio in the actively managed Large-Cap Blend asset class is 1.35 percent, diversified index funds managed by high-quality organizations can be accessed with expense ratios as little as .09 percent.”
Replace your mutual funds with index funds? Frankly, it “Bogles” the mind.
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