Active and passive investment management strategies have been locked in battle for decades now. Heavyweights on both sides of the argument cite academic studies and real-world fund examples to prove that their respective approach is superior, and investors continue to take sides.
Given the recent market downturn, however, investors seem to be losing faith in active management. To add insult to injury, now there's fresh evidence that actively managed funds are ending up on the losing side of the investing battle.
A recent Morningstar study revealed that not only do many active mutual funds fail to beat their respective indexes over time, but those that actually do accomplish that feat take on outsized risk to do it.
The study found that, over the most recent three years, while roughly half of actively managed funds outperformed their benchmark, only 37% did so on a risk-adjusted basis. Apparently, even those rare managers who do beat the market require extra amounts of risk to get the job done.
Of course, in the short run, this makes some sense if you think about the type of funds that typically suffer the greatest swings in performance and have the highest volatility. Performing a quick sort of Morningstar data, two of the funds that pop up with the highest 10-year standard deviation are ProShares UltraShort Nasdaq 100 (USPIX) and Berkshire Focus (BFOCX), with results of 61.9% and 51.5%, respectively.
The first fund provides twice the inverse of the daily performance of the Nasdaq 100 Index, which invests in big-name tech and health-care stocks like Gilead Sciences (Nasdaq: GILD ) , Cisco Systems (Nasdaq: CSCO ) , and eBay (Nasdaq: EBAY ) . Berkshire Focus is a super-concentrated fund with 540% annual turnover and only 27 holdings, including Research In Motion (Nasdaq: RIMM ) , Palm (Nasdaq: PALM ) , Intel (Nasdaq: INTC ) , and Marvell Technology Group (Nasdaq: MRVL ) .
The ProShares fund lost 80% in 1999, but was up 49% in 2002. The fund gained 81% last year, but is down nearly 60% this year. Likewise, the Focus fund posted an eye-popping 142% return in 1999, but lost 72% in 2001. It lost 57% last year, but is up 61% so far in 2009. Who can live with those types of stomach-churning swings? If these are the types of risks investors have to take to beat the market, it's no wonder indexing is gaining popularity!
Risk worth taking
So is this the beginning of the end of active management? Well, despite their many flaws, active managers aren't likely to be driven out of business anytime soon. One thing to consider is that ultimately, long-term returns are likely more important to investors.
While the Morningstar study took into account all those statistical measures like alpha and beta, these figures pale in comparison with strong market-beating returns. After all, it's not necessarily standard deviation that investors want to avoid, it's just deviation on the downside. Alpha and beta are useful measures, but they aren't always the most relevant ones for everyday investors.
Secondly, the study makes a solid point -- it often takes more risk to produce more return. That's why the funds you see sporting the highest standard deviation are typically very focused, concentrated options, or leveraged funds, like the two examples above. These funds can produce incredible returns if the stars align, but typically the next year, returns slide right back down to the basement.
Unfortunately, over the long run, these funds just don't measure up to the market, return-wise. This is an excellent justification for avoiding narrowly focused, high-risk funds and sticking with broader market, well-diversified options. The extra risk that these highly leveraged funds take on just doesn't end up working in shareholders' favor.
I won't deny that the majority of funds don't beat the market, on a risk-adjusted basis or otherwise, and that most aren't worth your time. But the truth, which was confirmed by the Morningstar study, is that some managers do consistently beat the market, and they do so with a lower level of risk.
This is the investing sweet spot, and these are the funds you want to own -- but such gems are rare. If you want a sneak peek at some of the very funds that measure up on these fronts, you're invited to check out the Fool's Rule Your Retirement investment service. With your free 30-day trial, you'll not only get the latest financial planning and retirement advice, you'll also get the inside scoop on which mutual funds are right for your portfolio.
The debate between active and passive management may continue for some time, but there's no reason why you should lose money while the academics and investment gurus battle it out. You can beat the market without taking on extra amounts of risk -- if you know where to invest.
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This article was originally published on Oct. 14, 2009. It has been updated.
Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement newsletter. At the time of publication, she did not own any of the companies or funds mentioned herein. Morningstar and eBay are Motley Fool Stock Advisor choices. Intel is an Inside Value recommendation. Motley Fool Options has recommended a bull call spread on eBay. The Motley Fool owns shares of Morningstar. Click here to find out more about the Fool's disclosure policy.