Academic journal article Journal of Accountancy

The Quest to Outperform

Academic journal article Journal of Accountancy

The Quest to Outperform

Article excerpt

Active or Passive Management?

"Investors, as a group, can do no better than the market, because collectively they are the market. Most investors trail the market because they are burdened by commissions and fund expenses."

-- Jonathan Clements, the Wall Street Journal, June 17, 1997

"Fees paid for active management are not a good deal for investors, and they are beginning to realize it."

--Michael Kostoff, executive director, The Advisory Board, a Washington-based market research firm. InvestmentNews, February 8, 1999

Is it a search for the Holy Grail?

The debate over whether financial markets are innately efficient rages on. Most academics argue that they are, making active portfolio management a loser's game where the odds of winning are so low it doesn't make sense to play. Active portfolio managers can't accept such an argument because it would put them out of business. Noted economist Paul Samuelson sums it up this way: "A respect for evidence compels me to the hypothesis that most portfolio managers should go out of business. Even if this advice to `drop dead' is good advice, it obviously will not be eagerly followed."

While the efficient-markets theory makes an interesting debate and provides useful insights into how markets work. investors really need to know the answer to this question: Can active managers consistently make money exploiting market inefficiencies after Factoring in the costs of their efforts? Mutual fund managers who have outperformed the market in the past make it seem easy, but identifying future winners is difficult. For the majority of investors, active management has achieved inconsistent and below-market results. Before recommending that clients or employers pursue an active portfolio management strategy CPAs and other financial managers should understand some of the costs that must be overcome for this approach to outperform the market.


Let's look first at the overall record of actively managed mutual funds for the 16-year period ending in mid1998. The annual return of all equity, funds that survived the period was 16.5%, or just 87% of the 18.9% return of the Wilshire 5000 index. An index fund with operating expenses of about 0.2% would have provided close to 99% of the returns available from the index it was tracking, including dividends. The difference in returns is actually understated, due both to survivorship bias (poorly performing funds disappeared from the data) and the impact of taxes on fund distributions. The 2.4% underperformance of all equity funds compared with the Wilshire 5000 index fund is caused by the fund's operating costs.

A study by Mark M. Carhart while he was at the University of Southern California--the most comprehensive ever done on the mutual fund industry--supports this data. After accounting for style factors (small-cap vs. large-cap and value vs. growth), the study found the average actively managed fired experienced annual returns almost 2% lower than those of its appropriate benchmark.

The SEC requires mutual fund prospectuses to provide information investors can use to make educated decisions. The required information includes investment philosophy, expenses and past performance. Expense information is generally limited to the fund's operating expense ratio and any 12b-1 charges (essentially marketing expenses the fund passes on to investors). Unfortunately, these expenses are just some of the costs active managers impose on investors in their pursuit of the Holy Grail of "outperformance."

Funds actually recur five types of expenses:

* Operating expenses and distribution fees.

* The cost of cash.

* Trading expenses.

* Market impact costs.

* Taxes.

Each of these expense categories creates overhead of 1% or more for active managers to surmount. For tax-deferred accounts, the active-management hurdle is at least 4%. …

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