Devoted to understanding the basics and fundamentals of investing

I took a quick glance at this a week or so ago. Very good reading.

Why does it always seem to come as such a mind-blowing surprise to so many investors that active portfolio management can (and frequently does) outperform any form of passive portfolio management, including indexing? Money managers have been looking for the holy grail of money management technique for centuries. Apparently, it is shocking to many of them that this does not necessarily equate to the laziest approach to money management.

I have read within other previous commentary on this very blog the contention that statistics prove passive indexing consistently outperforms active funds management. Nonsense. Don't believe it. I learned in my undergraduate statistics courses (and it took several attempts for me to finally pass one on them) that you can theoretically prove ANY concept with (sufficiently skewed) statistics, including the concept that an elephant can safely hang from a daisy over the edge of a cliff (as Kevin Costner pointed out to the jury in Oliver Stone's movie "JFK").

Indexed funds certainly have their appropriate place and undisputed popularity among astute investors, particularly with those focused upon investing in mutual funds, but to argue they consistently provide more superior alpha return than active portfolio money management expertise belies factual performance, and discredits the well-rewarded efforts of many managers, advisors, and traders who make their living working in the securities industry, including those of research analysts, to help others manage money successfully.

I don't think it's a suprise that they do, I think it's a suprise to most investors that their "actively" managed funds are infact, little more than index tracking funds with a higher expense ratio.

What I would be curious to see is if there is a point of diminishing return when it comes to the amount of holdings in a given portfolio and that said portfolios performance.

After the 'bubble', many funds are trying their best to reduce volativity by taking on more holdings, but are still charging for 'active' management.

Bob, it was good to see you and you were most kind to feed us a scrumtious dinner.

I don't believe I have ever stated that index funds outperform actively managed funds. What I have said is that active managers that add positive alpha are hard to find and are not very stationary, that is, they change from year to year. Also, because of fees, the added alpha is often consumed. Because the research to find these managers is difficult and has to be done regularly most retail investors will be better off in the long run in index funds. In fact, they will outperform the majority of actively managed funds.

In any given year, some actively managed funds will outperform. But not every year. Even Bill Gross and Warren Buffett underperform their indexes, sometimes for several years. It is evident now that they are superior investors when measured over decades. But their returns recently have been around average. And that was what the research showed, that as funds get bigger their returns approach the market.

Until the last sentence of your second paragraph above, you have not previously stated in this blog that index funds outperform actively managed funds. However, some of your (other) readership (besides me) has made that exact contention, in its commentary to your prior postings, and now (as of today) you have validated that same contention with your opinion expressed above.

I still respectfully disagree, for the aforementioned reasons stated above, and stand by my differing opinion in support of that reasoning. Of course, this is not the first time I have justifiably been known to be a disagreeable person. But do be careful about vociferously endorsing the practice of passive money management as a superior investment strategy, my friend, or you might just talk yourself right out of a job!

I beg to differ. Outperforming the majority of all activley managed funds is not the same as outperforming all actively managed funds.

Alpha is a zero sum game. Those who produce alpha take it from others in the markets. When you subtract transaction fees alpha is on average negative. That is, the majority of actively managed funds will produce negative alpha versus an index. That is one powerful reason why index funds are hard to beat.

Those who produce positive alpha are not stationary from year to year. It takes time and effort to identify them. Even a remarkable run like Peter Lynch cannot statistically be separated from pure chance.

The point of the blog above was that some actively managed funds really just replicate the index and the larger the fund the more likely that is to be the case. Investors should not pay for active management and have delivered index performance which is available at much lower cost. If you spend the time and effort to identify active managers who produce positive alpha, you are more likely to find them in smaller funds. Finally, if you want true active management and diversified performance random selection will not do. You have to manage the managers.

I second Mr. Stay.

In addition, if you want active management, the best is to do it yourself;)

Bob, for the sake of my education, could you provide an example of a fund that has outperformed its relative index (with management fees taken into consideration) over the long term (at least 20+ years)?

I would assume the difference in costs along with be enough to handicap any purely actively managed fund.

The reason I support indexing as suitable core investment vehicle to the general public is the simple fact of stability and simplicity. Emotionally, people would rather sacrifice high gains for the safety and security knowing that any respective index fund will most likely not take a big of lose as its actively managed peers.

It is my understanding that Janet Brown, President of DAL Investment Company in San Francisco and editor of "NoLoad Fund X" investment newsletter, has developed an interesting momentum-based "fund of funds" actively-managed "upgrade strategy" portfolio of the world's top-performing no-load mutual funds, which has outperformed the Wilshire 5000 index for over two consecutive decades. And her conservative growth funds appear to have consistently beat the S&P 500 handily, although they have not been in existance or under active management for 20+ years (yet).

I guess Peter Lynch's Magellan fund also wouldn't qualify for your serious consideration, since that large actively-managed fund was only under his direction for 13 years, during that limited period of time he was employed at Fidelity, and missed outperforming its index in two of those 13 years (although his outperformance during the other 11 years was nearly 30% over the index target per year). Pure chance? Nothing more than a "random walk"? That's quite a stretch of reasonable credulity, don't you think?

But I'll concede the point that Vanguard, T. Rowe Price, Neuberger Berman, a variety of bond funds, and other such equity fund sponsors, all of whom have actively managed mutual funds which consistently beat their index bogeys, also charge management fees which are significant enough to molify their net performance returns vs. passively managed index funds. As has been previously noted within this blog, you frequently get just about what you pay for (and little else), in today's world of high finance. Peace.