Active Managers Stink:

Excerpt from Barrons.com article.  {Excerpt with my highlights.}

Active Mangers Stink?  Blame These All-Too-Common Fund Flaws.

Chances are, your mutual-fund manager lagged the benchmark in recent years. Can you explain exactly why it happened?  Smead Capital director of research Tony Scherrer has an allergy to the standard Active management doesn’t work, just buy an ETF. He argues in a worthwhile look at the subject that the real explanation often has more to do with two or three unhelpful practices on the rise in recent years among active managers.

These are (1) a growth in the frequency of trading by fund managers, which is costly and (2) a drop in the number of managers whose portfolios are genuinely different from the benchmark. In order to beat a benchmark, you have to be different from it. And you can’t benefit from a stock’s rise if you’re constantly selling it out of your portfolios.

Those two factors, plus the impact of management fees, explain much of the recent poor performance versus the benchmark, Scherrer argues in the paper. Reduce or ideally eliminate one or more of these factors and a manager has a much better shot.

Train your eye on the upper grey portion of this graphic, which shows a steady shrinkage since 1981 in the proportion of fund-industry assets run by fund managers who exhibit “active share,” as the quality of being a manager who differs from the benchmark is called. Back near the beginning of the Reagan administration, it was around 60%. These days, it’s more like 30%

Scherrer’s chart, reproduced from the Financial Analysts Journal, shows the rise of “closet indexers,” which are the second and third groups from the bottom. It also shows the rise of purely passive investing vehicles — that’s the crosshatched portion at the very bottom of the chart. This passive group rises from the low single digits three decades ago to something close to 20% today.

Lump together the honest index funds and the active managers masquerading as active and you’ve got about 50% of the entire fund industry.

Now have a look at the second chart, which is reproduced from John Bogle’s Common Sense on Mutual Funds. This one shows mutual-fund portfolio turnover rising to something like 100% on average in recent years. This is a new phenomenon. Go back to the 1950s and fund turnover was one-fifth that rate. As recently as the early 1980s, it was half.

The previously cited Financial Analysts Journal study by Roger Edelen, Richard Evans, andGregory Kadlec shows the average annual costs associated with trading clocks in at an annual 1.44% for mutual funds. Break it down by category and some areas look especially bad. Small-cap managers averaged 2.59%.

“The most egregious offenders in this study handicapped themselves by nearly 2% with burdensome trading costs,” Scherrer writes. “These hidden costs may be the single largest factors of causation of active manager underperformance.” Throwing out the most egregious offenders in each of these practices yields a much better-performing group — and a stronger chance at outperformance.

 Link: Active Mangers Stink?  Blame These All-Too-Common Fund Flaws.