More Proof of a Losing Investment Strategy

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Like a monster in a horror movie, it's the debate that just won't die: Which is better, passive or active money management? Both sides have ardent supporters and passionate critics, and there are studies aplenty that seem to point the finger of truth in both directions. If you've got a stake in this discussion, a new report sheds more light on how the active vs. passive debate has fared in recent months.

Updated evidence
Standard & Poor's recently released its updated S&P Indices Versus Active Funds Scorecard, or SPIVA, for short. This rolling scorecard tracks how actively managed funds performed over the previous one-, three-, and five-year periods as compared to the relevant S&P benchmark. And as many might expect, the results weren't all that flattering for active funds.

According to the data, over the most recent five-year period, 57.6% of domestic equity funds underperformed the S&P Composite 1500 Index. Broken down by market cap, 61.8% of large-cap funds underperformed the S&P 500 Index, 78.2% of mid-cap funds missed the mark compared to the S&P Mid Cap 400 Index, and 63% of all small-cap funds trailed the S&P Small Cap 600 Index. That's not exactly a ringing endorsement for active managers!

The only category in which a majority of active funds beat their relevant benchmark in the past five years is large-cap value, in which nearly 65% of funds beat the S&P 500 Value Index. However, for all other equity asset classes, more than half of the actively managed funds trailed their index, including mid-cap growth funds, where a shocking 82.1% of funds lagged.

The high cost of failure
Five years is not a tremendously long period over which to examine results, but the evidence still speaks pretty clearly to a fact that many investors have known for a long time: The average mutual fund just can't beat the market on a long-term basis. While manager skill and plain old luck may account for much of the outcome here, one of the biggest challenges for active managers is overcoming the cost differential. Because active funds typically charge higher fees than plain old index funds or ETFs, in reality managers have to outperform the market to even give their fundholders a market return. Higher costs mean a higher performance hurdle to overcome.

That's why it's vital to pay attention to expenses when you're shopping for active funds. According to Morningstar data, the average domestic large-cap blend fund comes with a 1.28% price tag, while the average foreign large-cap blend fund charges 1.48% of assets every year. But there are some fund shops that don't charge obscene prices for their management skills. For example, take the Dodge & Cox lineup of funds. Dodge & Cox Stock (FUND: DODGX  ) comes with a mere 0.52% price point while Dodge & Cox International Stock (FUND: DODFX  ) charges only 0.65%. That's a whole heck of a lot less than the average such fund listed above! High costs just make it more likely that your active fund will lag. That's why it's so important to find the companies like Dodge & Cox that offer quality funds for a fraction of the cost of their competition.

The few, the proud
But even after accounting for active funds' higher costs, the majority of managers still won't be able to beat the market. It's simply very difficult to outguess the millions of other investors out there and see opportunities before others do. However, there are some managers who do have the unique skills and talent to rise above the rest -- it's just a matter of finding who they are.

Looking again at the Dodge & Cox fund family, we can see how some managers and management teams do consistently outperform the market. Rather than rely on a superstar manager, Dodge & Cox employs the theory that nine great minds are better than one. A team of nine portfolio managers runs the show at both Dodge & Cox Stock and Dodge & Cox International Stock.

The Stock fund looks for names that are temporarily undervalued but have good long-term growth prospects. Despite some difficulties during the recent financial crisis, the fund ranks ahead of 98% of its peers in the past decade and a half. Right now, management is finding a lot to like in out-of-favor pharmaceutical firms such as Novartis (NYSE: NVS  ) , Merck (NYSE: MRK  ) , and GlaxoSmithKline (NYSE: GSK  ) . Management sees great opportunity here, as health-care names boast attractive valuations, high free cash flow, and meaningful potential for long-term growth.

Likewise, Dodge & Cox International Stock boasts a 9.7% annualized return since its June 2001 inception, compared to a 5.4% showing for the MSCI EAFE Index. While this fund is just short of its 10-year anniversary, it has outperformed 91% of all foreign large-value funds in the past five years. The team finds the international telecom sector appealing and includes such names as the U.K.'s Vodafone Group (Nasdaq: VOD  ) , Finland's Nokia (NYSE: NOK  ) , and South African communications company MTN Group in the portfolio. Each firm boasts strong cash flow that should support dividends and potential share buybacks. The team believes innovation and growing demand from emerging markets should boost long-term demand for telecom services, so they have devoted roughly 13% of fund assets to this sector. This fund is an ideal core international holding for any investor.

Ultimately, the evidence shows that beating the market is an uphill battle for the average mutual fund manager. However, there is a rare group of funds and managers that can outperform the market over a long-term basis. Those managers are few and far between, but identifying them is key to out-earning the market and helping your portfolio reach its goals sooner.

To find out more about which mutual funds are primed to beat the market over the long run, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. Amanda owns shares of Dodge & Cox International Stock. Novartis and GlaxoSmithKline are Motley Fool Global Gains selections. Vodafone Group is a Motley Fool Inside Value pick. The Fool owns shares of GlaxoSmithKline. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 15, 2011, at 2:31 PM, prginww wrote:

    Active management loses on average. It's a bit of a rigged game, of course, since it would be impossible for most to beat the average since they in fact make up the overall average.

    As for apssive investment, think of it this way. SOMEONE has to be choosing their investments. if we all started investing through indexes, the index is going to be made up by the predilections of the few.

    Either or approaches I think are both for suckers.

  • Report this Comment On March 31, 2011, at 10:52 AM, prginww wrote:

    More simply put than wobatus; There are many thousands of mutual funds to pick from and more than half are terrible funds. They take an average of all of them and tell you an index fund is better than the average. So what! A well managed fund will outperform the average by a considerable margin. An index fund will beat the average by a few points. A well managed fund will beat the average by a huge margin. So, if you don't think you are capable of using all the data that is readily available today or you just don't want to be bothered, by all means, invest in an index fund. As for me, I will take a well mananaged fund and beat you by a large margin, every time.

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