A Stock-Picker’s Market?

Active management is the art of stock picking and market timing. In the face of depressed market prices and dramatic volatility, some investors and commentators have characterized this a “stock-picker’s market.” And, in fact, investors who believe they can accurately time markets or pick stocks should welcome such periods – high volatility and high cross-sectional dispersion (difference in returns across individual stocks) provides ample opportunity for active managers to distinguish themselves.

Unfortunately, despite the perception of increased opportunity, the challenge of succeeding with active management is no less daunting. In fact, according to the recently released Standard & Poor’s Index Versus Active Fund Scorecard, passively managed funds outperformed actively managed funds for the one, three and five year periods ending December 31, 2008.

Between 2004 and 2008, the S&P 500 Index outperformed 71.1% of actively managed large-cap funds, the S&P MidCap 400 Index outperformed 75.9% of mid-cap funds and the S&P SmallCap 600 Index outperformed 85.5% of small-cap funds. Similar results were reported for international equity funds.

The belief that bear markets strongly favor active management is a myth,” said Srikant Dash, global head of research and design at Standard & Poor’s. “The bear market of 2000 to 2002 showed similar outcomes.”

There are two major pitfalls of active management. First is the efficiency of the market itself – the stock-market pricing system is effectively a vast information-processing machine that registers the implications of all information held collectively by investors worldwide – no single investor can consistently know more about any individual security than does the market as a whole. For an active manager to succeed, the markets (consisting primarily of professional investors) must fail to correctly price an individual stock, and that manager must identify the mispricing and act on that information before it is recognized and corrected by other market participants.

The second major pitfall is cost. Regardless of market conditions, active management is always a zero sum game before expenses – if there are active winners, they win only at the expense of active losers. However, active management is always a negative sum game after expenses.

Mark Kritzman, President of Windham Capital Management and graduate-level professor of financial engineering at M.I.T.’s Sloan School of Management, recently released a study measuring the long-term impact of the increased expenses associated with actively managed mutual funds and hedge funds (including transaction costs, taxes and management and performance fees).

“It is very hard, if not impossible,” he wrote in his study, “to justify active management for most individual, taxable investors, if their goal is to grow wealth.” He added that those who pursue actively managed strategies are almost certainly “deluding themselves… Even in a tax-sheltered account, the odds of beating the index fund are still quite poor.”

In the end, most stock pickers – professionals included – do worse than if they had never tried to pick stocks at all. Despite the seductive allure of active management, the best way to win the game is to not play it.

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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