Active vs. Passive Management

Most mutual fund managers and advisors invest with an active approach. The profile of a large actively managed mutual fund reads as follows:

“ABC fund seeks capital appreciation. The fund invests primarily in common stocks of domestic and foreign issuers. It invests in either “growth” stocks or “value” stocks or both using fundamental analysis of factors such as each issuer’s financial condition and industry position, as well as market and economic conditions to select investments.”

Allow me to put that into plain english:

“ABC fund tries to make our investors money. We do so buy buying and selling stocks of any variety. We analyze companies and we research the economy, and based upon our analysis we try to select superior stocks.”

Now let’s listen to a typical pitch to a prospective investor:

“ABC fund is an excellent investment. The manager is highly respected and has been written up in Money Magazine. In fact, ABC fund has beaten the S&P 500 index over the past ten years! ABC fund is rated five stars by Morningstar, and has consistently beaten the Lipper averages. It is very helpful to have a manager such as this who has the educational background and long experience to guide you through these volatile markets.”

Sounds pretty convincing, doesn’t it? Most investors rely upon their advisors, and based upon the information given, they would buy the fund. But would you be surprised to find that the described fund has no better chance of beating the market than any other fund, including funds that are rated one star by Morningstar? How can this be? To illustrate, let’s look at a hypothetical situation:

Eight thousand people are sitting in a large room. Each is given a quarter and asked to flip it ten times. At the end of the exercise a small handful (most likely fewer than ten) will be able to truthfully proclaim: “I flipped heads all ten times!” Here is the question: If your financial future depended on it, would you select those same people to repeat the feat? Would you expect those same people to be able to flip heads ten times again? Of course not; you understand that it was random chance that allowed them to do it the first time. Anyone in that room is as likely as they are to repeat the feat, but few are actually likely to do so.

Likewise for active mutual fund managers. The overperformance of our hypothetical mutual fund is due to random chance. Any fund manager is as likely as they are to beat the