"Active" versus "Passive" Investing

Today, the Wall Street Journal reports on a recent study by Morningstar. Selected excerpts follow:

"While it has been established that most actively managed mutual funds lag behind their indexes over time, a new study further twists the knife: Active management suffers even more by comparison on a risk-adjusted basis.

The study found that in many cases where an actively managed fund beats its index on an absolute basis, the additional risk it took didn't justify the returns earned. Not only should that be a warning sign for investors -- because greater risk means greater volatility -- but it also suggests that fund managers aren't living up to what is expected of them.

The study by Morningstar Inc. found that, over the past three years, while about half of actively managed funds outperformed their respective Morningstar indexes -- which cover the nine different Morningstar investment styles -- only 37% did on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns.

"It's not enough to beat an index in a way (that assumes more risk)," said Travis Pascavis, director of equity indexes at Morningstar. A riskier fund should provide greater returns, he added.....

The key to thinking of risk in terms of returns versus an index, he said, is that, in theory, if investors wanted to take on more risk for greater returns, they could simply buy an index fund and lever up their exposure. That would also increase returns while adding risk -- and do so at a cheaper cost than most actively managed funds. It is against this standard that actively managed funds should be judged, he said....

Mr. Pascavis said it is important for investors to be comfortable with the risk they are taking on when they buy a mutual fund. What is more, his study found that if a fund has higher risk, it is often a sign of an underperformer: Funds performing in the top 25% over the past three years had much lower risk and volatility than their peers.

"There is generally a positive relationship between risk and return, where better-performing funds are riskier; however, this has not been the case over the last three years," noted the study, which added that poor returns of the recent market likely helped less-risky funds.

Even in absolute terms, the results highlighted the shortcomings of many actively managed funds. Over the past five years across the nine Morningstar-style boxes -- value, core and growth in the small-cap, midcap and large-cap sectors -- only large-cap growth and midcap value saw more than half of active managers beat their indexes..... "
_____________________________________________
Sam Mamudi, Active Management Loses in Risk Study, New York Times, September 8, 2009

Buffett would agree with the findings of this study

"Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders......."

Warren Buffett, 1996 Letter to Berkshire Hathaway Shareholders

In January 2008, to prove his point, Buffett entered into a bet (each side put up $320,000, with the final proceeds going to the winner's favorite charity) with Protege partners, a fund-of-funds hedge fund, that their handpicked funds will not beat the S&P 500 index over the next 10 years. A principal of Protege said, "Fortunately, for us, we're betting against the S&P's performance. not Buffett's"