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In investments, rolling the dice at the active-management table

By - Last modified: May 4, 2012 at 10:15 AM

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No matter how great the odds of losing, people love casinos. Investment firms, of course, don’t have the pizzazz, the bars, the bright lights and other sensory stimulation found in casinos.

Although firms that engage in active investment management don’t have the alluring ambiance of a casino, their investors, often without realizing it, are gambling nonetheless. And though they may win for a while, most of them ultimately lose, just as casino gamblers do.

Active management is when investment managers buy and sell securities based on their speculation on which way they may be headed. By contrast, passive management (using vehicles such as index funds) involves no such speculation, because these investment vehicles are composed of the majority of securities making up a certain benchmark or index, such as the S&P 500. Roughly one-quarter of all assets currently invested in mutual funds are now in passively managed vehicles, such as index funds.

In the past several years, more and more investment dollars have been flowing out of actively managed mutual funds, which have lost $400 billion over this period, and pouring into index funds, which have gained $600 billion.

Even when an actively managed mutual fund does relatively well, its investors most often are paying dearly for this performance in fees and expenses, which severely slice into net returns. That’s why even America’s most famous investor, Warren Buffett, has recommended low-cost index funds as the best choice for most investors.

Active management can be successful for years on end, merely because of pure randomness — and then the big hits inevitably come. Studies have shown that many active managers actually contribute to their gains by acting as closet indexers, managing their portfolios to reflect indexes to a large extent. Active managers often look back at different indexes’ performance in recent years and then, mimicking these indexes, do well for a while. But eventually, they begin to buy and sell based on their own speculation, all the while being weighed down by heavy expenses.

Jack Bogle of Vanguard, the inventor of the first retail index fund, has said it’s easy to see where the back-testing ends and the results from active managers’ actual judgment begin: “The great becomes the ordinary.”

And from ordinary, results often go down the slippery slope to poor — below what major indexes are offering. Once this happens, investors are paying high fees for which they could get an institutional asset class fund, or even a low-cost generic index fund. This is a situation where the managers aren’t earning their seven-figure salaries.

This is why even the most successful active manager’s winning streaks almost always eventually tank. While they’re hot, they’re treated like rock stars in laudatory press articles and listed among Morningstar’s Managers of the Year. But eventually, the odds and expenses of active management catch up with them, and investors who don’t get out of their funds in time pay a big price.

Meanwhile, passive investors or index investors — who typically don’t experience the lucky streaks and huge run-ups that some active managers randomly may deliver for a time — often don’t experience the same magnitude of losses, and thus may progress more steadily and efficiently toward their goals.

The risks of stock speculation — and active management— have been widely known for some time. In 1914, Supreme Court Justice Louis Brandeis warned that rampant stock speculation would eventually lead to a market collapse because of what he called “the relentless rule of humble arithmetic.” The simple rule is that for every winner there must be a loser. Thus after expenses, the majority of investors will underperform the benchmarks.

Those who pledge to avoid the seductive, speculative world of active management and instead capture the returns of the capital markets (versus trying to outsmart them) know that despite hype and hope, simple arithmetic never changes. Just ask the owners of casinos.

Tim Decker, a fee-only financial planner, is president of ISI Financial Group in Lancaster. He is the author of “The Sleep-Well-At-Night Investor” and host of the radio program “Financial Freedom,” which airs at noon Saturdays on WHP-AM 580. Contact him at www.isifinancialgroup.com.

Write to the Editorial Department at editorial@cpbj.com

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