Most mutual fund managers and advisors invest with an active approach. The profile of an actively managed mutual fund (hypothetical) 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 by 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? 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. Some active managers have been able to beat the market. But how much assurance do we have that the manager we selected based on past performance will be successful in the future? Studies* have shown that our chances are not good.

*A recent Morningstar study found that of 452 domestic equity funds in their database that had existed for 20 years, only 3% outperformed their respective indexes. And, this doesn’t take into account survivorship bias; the funds that survived were the better performing funds. DFA examined survivorship bias for July 2004-June 2009. They found that, on average, 5.7% of the actively managed fund universe disappeared each year. In that study they also found that 63% to 90% of active equity funds and 93% to 100% of active fixed income funds underperformed their matched indexes. And, only about 1.4% of actively managed funds outperformed their benchmark over the five year period. Another study found that of the 248 stock funds receiving Morningstar’s (highest) five star rating in January 2000, only four, or 1.6% kept that rank after ten years (12-31-09).