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Learn From the Pathetic Excuses of Active Managers

Daniel Solin

It has been a tough year for active managers and for the financial media, which gives them a forum to tout their stock picking skills. You know there is trouble in paradise when CNBC (the home of Jim Cramer) publishes an article entitled: Why the Days of Stock Picking May be Coming to an End.

It's hard to quarrel with the premise. Jeff Cox, a senior writer at CNBC, notes that only one in five active managers are beating their benchmark year-to-date in 2012, even though this year was "marked by the same type of headline volatility caused by events in Europe and fiscal concerns closer to home."

How could this be? I thought market volatility was a benefit to active managers. It was supposed to give them the opportunity to demonstrate their investing expertise. One of the biggest active managers, Principal Global Investors, prepared a research report extolling the virtues of active management. Here's one of its key findings: "Market volatility will offer significant opportunities for active managers to deliver favorable returns."

Edward Jones agrees. In its view: "It appears that controlling volatility and helping to limit losses when times get rough are often the biggest potential benefits active managers may provide."

So how do active managers explain their dismal performance in a volatile market? Largely through double-talk. Gary Flam, an active portfolio manager, notes that it has been "a tough couple of years for active." He explains that investors have to have "a forward-looking view."

Were Flam and his active colleagues looking backwards for the past couple of years? According to Flam, investors should seek advisers "who can see through the fog of politically driven markets with tight correlations." I guess the "fog" obscured the vision of 80 percent of active managers.

Even more nonsensical advice was offered by Jeff Coons, president and co-director of research at another active management firm. He advises investors not to judge the industry as a whole but instead to "focus on individual managers with sound strategies to navigate bubble and post-bubble markets."

Do you think it makes sense to ignore the data indicating that 80 percent of active managers failed to beat their benchmarks? Since you will be looking for a needle in a haystack, how exactly will you determine which individual fund manager is likely to outperform his benchmark prospectively? Focusing on individual managers with "sound strategies" means you will be basing your decision on past performance. That might be a good idea if past performance was a reliable indicator of future performance, but it isn't. There are numerous studies showing that manager performance does not persist. To my knowledge, no one has published a peer-reviewed paper showing a methodology for selecting outperforming active fund managers prospectively with greater accuracy than you would expect from random chance.

Unfortunately, the predicted demise of stock picking (and with it, active management) is premature. The securities industry has too much too lose. The partnership between the securities industry and the financial media is too lucrative to change. While progress is being made, we still have a long way to go until solid data triumphs over hype and pathetic excuses.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, The Smartest Portfolio You'll Ever Own, and The Smartest Money Book You'll Ever Read.

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