Investment Articles

04/28/03 - Where Are They Now? Update

By: Frank Armstrong, CFP, AIF

Just in case there is some misguided soul somewhere on this planet that still thinks that managers add value consistently, or that past performance is an indication of future performance, I have updated the figures to my previous article "Where Are They Now?"

Basically, we pulled out our rusty old Morningstar Disk with results ending December '97 . We then asked the Morningstar software to rank returns of the Morningstar Category "Large Growth" for the previous five year period, screening out any funds that held more than 10% foreign equity. We found 226 funds. Of these 226 we nominated the top twenty funds as our active manager heroes.

Bigger Was Better
Domestic large companies were the place to be during the covered period. In fact, in some circles, the S&P 500 index was considered the complete balanced portfolio. Big was definitely better. Back then tech stock/ dot.com/ new economy/ new metrics mania hadn't arrived quite yet.

It was a tough environment for managers. The domestic markets were unbelievably generous, but, the largest of the large dominated performance. Few active managers were able to beat the S&P 500. The best performing managed fund  came in with 23.81% annual return. The S&P 500 turned in a stunning 20.25%, while the average of the top 20 funds turned in 20.21%. While eight of the top twenty beat the benchmark, on average the top twenty funds fell short. If you are following the math here, in the total group 218 of 226 fell short of the index!

Frankly, we normally expect more managers to beat the index. While hardly a ringing endorsement for active managers, it gets even worse.

If however you still believe that active managers can add value, and that past performance is any indication of future performance, then you would assume that a subsequent time period would find these twenty funds rising to the top of the heap again, right?

Active managers are fond of saying that even if they have a tough time beating the market in good times, they can protect capital through skill and cunning during bad times. The following five years gave them the perfect opportunity to prove it. They were a time of great turmoil and transition. The dotcom bubble built and burst taking a large part of the previous decade's gains with it. If ever there was time for active managers to shine this should have been it.

This argument flunks convincingly when we examine the date. We fast forward five years to look at the five year results as of December 2002. The group of funds passing our screen with a five year track record has grown from 226 funds to 1172 funds. After a wild and hairy ride, the S&P 500 returns shrank to a very disappointing 0.58%.

Fund Name	Order	5 Year Total Ret Annualized	% Rank
Spectra	250	-1.9	43
Robertson Stephens Val+Growht A	#	#	#
Enterprise Growth A	153	-0.44	26
White Oak Growth Stock	412	-4.52	71
Enterprise Growth and Inc. Y	126	-0.08	27
Founders Growth	518	-7.57	89
Putman Investors A	361	-3.81	82
Harbor Capital Appreciation	204	-1.16	35
Pioneer Growth A	510	-7.37	87
MFS Massachusetts Inv Grth A	162	-0.6	28
Papp America-Abroad	376	-4.05	65
Vanguard Index Grwoth	191	-1.09	33
Gabelli Growth	328	-3.13	57
State St Exchange	62	1.18	16
Universal Capital Growth	*	*	*
IDS Growth A	483	-6.31	83
Fidelity Adv Eqty Grth Instl	157	-0.48	27
AIM Blue Chip A	342	-3.35	59
Janus Growth & Income	43	3.96	6
Diversification	*	*	*
Fund Average	1172	-2.40
Index: S&P 500 # Fund has changed investment style * Fund has disappeared or merged		-0.58

Of our original twenty top funds, two funds have disappeared or been merged away. Another fund changed its investment objective, leaving just 17. We didn't / couldn't calculate their returns, probably distorting the results (in favor of the active managers) due to the survivor bias. Of the remaining seventeen funds, two maintained top quartile performance against their peers, seven fell to second quartile, and eight fell to bottom half. Four funds found themselves in the bottom 20% of the pack, and the worst sank to the 89^th percentile against it's peers. The average of all 17 funds fell to ý2.40%, or not significantly different from the ý2.68% that the entire 1172 funds experienced.

The worst fund from the original surviving 17 (Founders Growth, which was number 6 during the first period) fell to a compound return of ý7.57% or about 5% compounded below the index, convincingly demonstrating that active management adds rather than reduces investment risk.

We would have predicted that all funds would have trailed the index by about 2%, an amount equal to their expenses and trading costs. That's almost exactly what happened.

We also would have predicted that the top performing funds during the first period would have random results in the trailing period that were not significantly different from the total group. That's almost exactly what happened.

If the first period results were any indication of skill and cunning, then we would expect them to be duplicated in the second period. But, the 17 surviving top performing funds from the first period were able to collectively under-perform the index by a about 2%.

It's worth mentioning that the above results are computed before we consider the impact of taxes. But, active managers generate so much turnover while futilely pursue their holy grail of outperforming the relevant benchmark index that they systematically destroy capital for taxable investors.

Active management generates enormous fees when compared to passive or index investing. So, we can't expect active managers to give up without a fight. They don't. Rather than admit it's all a hoax, they invest part of their fees in marketing to promote active management as a value added service. This enormous marketing effort pre-conditions investors to do just the wrong thing. But rational investors looking at the facts should overwhelmingly choose passive or indexing as the lowest cost, lowest risk, lowest tax cost, most effective method to achieve their investment goals.

So, after just a few moments of reflection we should all absorb these4 lessons:

1. Past performance is no indication of future performance

2. Active management will produce an average return of about 2% below the appropriate index.

3. Choosing between active managers on the basis of past performance is a brain dead, proven losing strategy.

4. Active management adds rather than reduces investment risk.

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