The Deceptive Returns of Active Managers

A colleague related this sad story about the death of his elderly mother. Nearing the end of her life, she was in a coma in the hospital and it was clear to him she would not survive. He had always promised her she would not have to endure extraordinary measures to prolong her life if there was no realistic chance of recovery.

The doctors asked if he wanted her to go on a respirator. He responded with an inquiry about her chances of survival. "There's always hope," they told him. He consented to the use of the respirator. She died two days later.

"I felt I lost twice," he told me. "Once when she died and another time because I didn't honor her wishes."

What does this have to do with the returns of active managers?

Part of the financial media's agenda, it appears, is to give you "hope" that there's a guru out there who can reliably and consistently "beat the markets." Otherwise, you will succumb to the data supporting evidence-based investing, costing the mutual fund industry billions in profits.

It's not just shills like Jim Cramer who engage in this deception. Reliable sources of financial information join in with enthusiasm, adding misplaced credibility to the process. A recent example was a fawning article in Financial Advisor. It told the compelling story of Albert Nicholas, fund manager of The Nicholas Fund (NICSX), who the magazine anointed as its "No. 1 ranked fund manager." According to the article, Mr. Nicholas "has topped the Standard & Poor's 500 Index by an average of 2 percentage points a year for the past 40 years and has beaten it every year since 2008."

The article used Mr. Nicholas as an example of stock pickers who can "beat their benchmarks" over the long haul, thereby debunking the views of "some prominent academics" who question the value of active management.

Sounds very impressive. Maybe you should consider using Mr. Nicholas or another adept stock picker to manage your portfolio. That seems to be the point of the article.

Most investors don't have the quantitative skills or experience necessary to take a deeper look at the returns of The Nicholas Fund. Fortunately, Tom Allen and Mark Hebner at Index Fund Advisors don't suffer from that disadvantage. When they analyzed the returns of The Nicholas Fund, they came to a much different conclusion. Here's what they found.

Improper benchmarking

The Morningstar-assigned benchmark for The Nicholas Fund is the Russell 1000 Growth Index and not the S&P 500. It's misleading to compare the returns of this fund to any benchmark other than the Russell 1000 Growth Index.

Since 1979 (the beginning of the index) The Nicholas Fund beat the returns of the Russell 1000 Growth Index in some years and unperformed it in 15 other years. In 1999, the fund was down more than 30 percent relative to its benchmark. Over the entire period, from 1979 through 2015, it did have an average "alpha" (outperformance) of 0.79 percent.

Luck or skill?

Allen and Hebner calculated the "t-statistic" (a measure of statistical significance) of the fund's alpha to ensure that they weren't "being fooled by randomness." They concluded: "We can be less than 20% confident that this performance is in fact a display of skill and not just random luck."

At this point in the analysis, we know there are two things missing from the article in Financial Advisor:

1. When you use the correct benchmark, Mr. Nicholas did not outperform for 40 consecutive years.

2. The average outperformance (alpha) of The Nicholas Fund is most likely due to luck and not skill.

It gets worse.

Style drift

Over time, The Nicholas Fund shifted its portfolio from small-cap value stocks to large-cap growth stocks, then to large-cap value stocks, back to large-cap growth stocks and now mainly to large-cap value and large-cap growth stocks. The analysis found that, when compared to the entire market, The Nicholas Fund, on average, has been "slightly smaller and more value oriented."

When these factors are taken into account, the fund's alpha is reduced to a minuscule, and statistically insignificant, 0.04 percent.*

I am not suggesting Mr. Nicholas isn't a fine fund manager, but the hype about beating his benchmark for 40 consecutive years clearly doesn't withstand scrutiny.

It's not impossible to find an active fund manager who will "beat the markets." It's just that the large odds against doing so make it unwise to try.

* This alpha was calculated using a Fama-French three-factor regression.

Dan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.