As surely as we saw the ball drop in Times Square, at the turn of the year we see predictions that this year, unlike last, will be the year when active equity management shows its true value. Of course, similar predictions were made a year ago, and they didn’t work out particularly well, but that never seems to diminish the confidence of the new year’s forecasters. A cynic might remember Upton SInclair’s observation that “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
One current argument for active management is that, with the S&P 500 and Dow Jones Industrial Average near all-time highs, the consequently heightened possibility of a bear market means that active managers are needed to mitigate risk. This sounds like an appealing thesis; unfortunately it is untrue. In the dozen years since our SPIVA reports began to keep score on U.S. active managers, there have been only two bear market episodes. In the 2000-2002 deflation of the technology bubble, and again in the financial crisis of 2008, 54% of large cap funds underperformed the S&P 500. Mid-cap and small-cap performance was even worse. Whatever else one might say of active management, it is clearly no sure port in an investment storm.
Does that mean that successful active management is impossible? Certainly not — but investors who are contemplating it should understand, as a matter of both theory and empirical evidence, that success is unlikely. On the other hand, as Ellis has recently argued, true value added is more likely to reside in investment counseling than in portfolio management. Advisers who can keep their clients from succumbing to the alternating temptations of fear and greed perform a valuable service. Advisers who think they can identify active fund managers who will reliably outperform their index benchmarks, on the other hand, should realize that the odds are against them.