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Study: active investors not dumb

By Sheyna Steiner ·
Friday, February 4, 2011
Posted: 7 am ET

To paraphrase Henry Louis Mencken, no one ever went broke underestimating the intelligence of the American people.

Does that explain the overwhelming popularity of actively managed mutual funds compared to index funds?

No – according to new research from Robert F. Stambaugh, a finance professor at the Wharton School of the University of Pennsylvania.

Stambaugh has found that fans of actively managed funds may be behaving rationally despite the fact that index funds, on average, outperform actively managed funds. His research is described in a story on the Knowledge@Wharton Web site, "If index funds perform better, why are actively managed funds more popular?"

Studies have shown that actively managed funds often fail to beat their benchmarks and when they do perform better, fees and expenses can negate the extra returns.

A 2009 story from the New York Times, "The index funds win again," detailed one such study.

Mark Kritzman, president and CEO of Windham Capital Management in Boston, Mass., found that after taking fees, expenses and taxes into account, an actively managed fund would need to outperform an index fund by 4.3 percentage points per year on a pre-expense basis.

Actively managed funds do better in a tax-favored account such as a 401(k) or an IRA because taxes account for such a large portion of expenses, however, "even in a tax-sheltered account, the odds of beating the index fund are still quite poor," Kritzman says in the New York Times story.

So what's wrong with these investors who subscribe to an active-management approach? There's a bunch of them. According to the Knowledge@Wharton story, only 13 percent of equity mutual fund assets are in index funds.

From the story:

"It doesn't seem to make sense. Experts have offered a variety of explanations: Investors are duped by slick managed-fund marketing, they don't know the facts or they believe 'you get what you pay for' … All those explanations have one thing in common: They assume investors are not very bright."

Stambaugh and the co-author of the research report, Lubos Pastor, finance professor at the University of Chicago Booth School of Business, found that investors in active funds are neither unaware of the impact of fees and expenses, nor are they naive to the fact that managed funds do less well over time than index funds.

However, the investors do bet on their ability to pick the funds that will outperform. They also are betting that other investors will drop out of the race for performance, making it easier for their fund manager to find and exploit bargains.  

Stambaugh and Pastor came to the conclusion that investors must view the concept of alpha as inconstant. Alpha measures the performance of an investment, after accounting for risk, compared to its benchmark.

Instead of just giving up after a period of poor performance, "the rational investor realizes that other investors will pull some of their money out of actively managed funds, making bargain finding easier. The investor will also pull only some of his own money out, because he wouldn't want to miss the chance of improved results after others pull money out," the story concludes.

The story also notes that the debate over active versus passive management is similar to that of meat-eaters and vegetarians, with each side fully entrenched in their position and completely convinced of their own argument.

Do you think the research explains the popularity of active management? Do you use an active or passive investing style, or a combination?

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