What is Active Fund Management and why should it be avoided?

Although many alchemists were indeed crackpots and charlatans, many were well-meaning and intelligent scholars, who were simply struggling to make sense of a subject which, as we now know, was far beyond the reach of their tools. They had to rely on unsystematic experimentation, traditional know-how, rules of thumb — and plenty of speculative thought to fill in the wide gaps in existing knowledge. The alchemists did not follow what is now known as the scientific method, and much of the “knowledge” they produced was later found to be banal, limited, wrong, or meaningless.

“Definition of Alchemy,” taken from Wikipedia

Just as the alchemists of old pursued a belief that base metal could be transformed into gold, active investors operate under the illusion that there is some special knowledge or understanding of the market that would enable them to predict the future direction of prices.

This activity could more accurately be described as speculation, or gambling, as by failing to realise just how much their investment performance depends on luck, most “investors” end up paying dearly for their mistake. Active fund management is no different, except to the extent that it involves gambling with other people’s money – and being paid handsomely for it.

In 1986 a report was published by a prestigious firm of pension consultants in the United States. This firm had analysed the performance variations of 91 large pension funds and reached a profound conclusion – one which sent a collective shudder through the investment community.

The report’s authors found that of the three primary investment strategies that determine portfolio performance: market timing, stock selection and asset allocation, it is the latter – asset allocation – that accounts for over 90% of the variation in returns of a diversified portfolio.

In contrast, the activities and recommendations of most stockbrokers and fund managers are based on market timing and/or stock selections which are, in effect, attempts to predict the future. Hundreds of millions of dollars or pounds are spent by these firms each year to try and derive some competitive advantage. However, the net result of this activity, which is ultimately paid for by investors in management fees, is that not only does it not add value; it is more likely to subtract it.

The evidence that market timing (the belief it is possible to pick the times to be in or out of the market) and stocking picking (attempting to find stocks that the market has mis-priced before the price is corrected) does not work is compelling and endorsed at the highest levels. In their exhaustive study of the performance of UK fund managers Garret Quigley and Rex Sinquefield concluded:

This examination of UK equity unit trusts says that UK money managers are unable to outperform markets in any meaningful way, that is, once we take into account their exposure to market, value and size risk. This result is analogous to most studies of US money managers. Even more dramatic than these overall results are the findings for the small-company unit trusts. Contrary to the notion that small-company shares offer abundant ‘beat-the-market’ opportunities, we find that small-company unit trusts are the worst performers. In fact their performance failure is persistent and reliable.

The UK Financial Services Authority (FSA) also reached its own conclusions as to the value of active fund management. For example, the following exchange took place during a hearing of the House Treasury Committee at Westminster on 3rd May 2006. Giving evidence on behalf of the FSA was Mr Clive Briault, Managing Director, Retail Markets (source: Hansard).

Mr Newmark MP: I am just trying to understand, is there an advantage to going into actively managed funds and do those people whose funds are being managed benefit from more actively managed funds or is it just a means for active fund managers to make more money because the average consumer is not benefiting from that?Mr Briault: Well, when you say “make more money”, of course there is also a cost to the firm of actively managing the fund and it is a question of how those costs are then reflected in the charging structure. In competitive markets, you would not expect the firm necessarily to make a lot more money —-Mr Newmark: No, I understand that, but is there any evidence that actively managed funds are performing better than tracker funds?Mr Briault: No.Mr Newmark: You are saying no?Mr Briault: Yes, absolutely.Mr Newmark: So the only people benefiting from this are the fund managers?Mr Briault: Well, depending on the charging structure related to the costs of running the actively managed fund, yes.