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Why Active Management Does Worse in Real Life than it Should in Theory

When it comes to managing a portfolio, there are two schools of thought: active management and passive investing.

With active management, a fund manager depends on his skill and valuation abilities to improve performance. The major draw for passive management is that there is no effort, and thus the investor can’t sabotage his own progress through his actions.

All things being equal, an active manager who is an above average allocator and determiner of company value should achieve above average results. However, all things are not equal– and there are other uphill battles that active fund managers have to face that can hurt portfolio performance.

In this blog post, I’ll quickly go over some of them so you can see why active management can be much easier said than done, especially when it comes to the biggest hedge funds and mutual funds.

active management

Before I start really digging in to the realities behind active management, first we should look at what people believe about it.

There’s a strong divide in the investing world between fans of active vs passive management. The passive investing crowd believe that paying management fees are a waste of time because an overwhelming majority of them can’t beat the market.

While there’s truth to this statement, you can find countless studies that simply cherry pick data to make this point. Take this article that says that only the 95th percentile of active managers were able to beat the market over a 15 year time period. In a textbook example of cherry picking, the article cites a study that looked at one time period: the one ending in 2017.

If a study only looks at a single time period, such as 2002-2017 as this exact study did, you can’t make any reasonable conclusions from it. Why? Because the stock market is constantly changing and stocks, sectors, and strategies outperform and underperform all the time.

While most passive investors agree that active management is inferior because of studies like these, it’s not fair to jump into a conclusion like this based on a cherry picked study.

What this really amounts to is a viewpoint from a cynic rather than an observable fact from real life results.

But here’s the other factor that this study (and many others) don’t consider.

And it gets overlooked because it is so simple.

Why Active Management Often Fails

Fund managers can’t beat the market because the system is set up so they can’t. Look, the fact that a fund manager is doing this full-time to support himself or his family is EXACTLY why he can’t beat the market.

Relate it to your own vocation.

How many of us do what we can at our job to not rock the boat, even though a different way might get better results? Unless you work at a startup, it’s usually more advantageous (if you want to keep your job) to follow the system that’s already in place rather than blaze your own.

And so most of us (smartly) do this.

If you see your boss doing something inefficiently (I don’t have to worry about this currently), is it better to keep quiet or put him on blast (or even mention it) so he’ll change his ways for the better of the company?

Probably not. You got to be smart and look out for numero uno.

In the same token, active fund managers need to follow the script if they want to keep their job. That means getting results as close to the market average as possible– because severe underperformance means bye-bye.

If you look at stock market strategies that have been historically successful, they have NEEDED periods of underperformance to set-up future outperformance.

No one active management strategy, even Warren Buffett’s, has had perfect long-lasting outperformance every single year for decades. There’s times of underperformance, but the outperformance in the other years is so great that it overshadows a couple bad years and then some.

But what about the fund manager? A 3 year time period with bad underperformance? You’re canned.

And what’s funny is– something Jim O’Shaughnessy talked about a while back on his son’s podcast— is that the fund managers that are canned for bad 3 year underperformance consistently beat the new fund managers that take over.

Because remember, higher gains happen by going against the crowd. You make decent money buying stocks when everyone else is (bull market), but you make the real money buying when everyone else is not (bear market).

Buying against the crowd means hanging in there when the stocks you own or buy continue to fall. Patience and persistence.

Another way to not “rock the boat” is to dress up the portfolio with the same stocks everyone else is buying– the majority of new investors want the same stocks the majority already has.

These are the REAL problems with active management.

How does this apply to the average investor?

Remember what I said at the top about the passive management crowd coming to poor conclusions based on data. Now that we have a better understanding of why active management doesn’t perform as well as it should in theory, we need to make our own useful conclusions.

One possible conclusion is that since active managers can’t beat the market, then an average Joe investor certainly can’t since they don’t do it full-time like these experts.

Now that you’ve read this article, do you really agree with that? Hopefully you can see that’s faulty logic, and that the full-time career status of most active managers actually hurts rather than helps their portfolio performance. Rocking the boat is a great way to lose.

Another possible conclusion is that maybe active management itself isn’t so bad, but today’s system makes investing with them bad. Between management fees and the tendency to end up with a bad track record, maybe an average investor shouldn’t buy into hedge funds and mutual funds, and should look into a more DIY approach.

diy investing

From there, the question isn’t whether active or passive management is better. The question becomes is active or passive management better for you.

And that’s where this whole passive vs. active management debate needs to change its focus.

You must ask yourself some simple questions…

Do you find business and business financial fascinating? Do you feel excited and energized by the idea of going against the crowd? Do you think you can be more rational when everyone around you is being emotional? Do you have a stock picking strategy that you believe and feel confident in? Do you have the desire to take the time to be a good active manager of your own portfolio?

These are much more insightful and results-driven questions to answer rather than just cloaking a blanket statement that passive management is simply better than active management.

Because, really, it’s simply not.

It’s just that the discussion is happening the wrong way.

If you feel like you’re an investor who wants to think about managing his own portfolio, then I recommend educating yourself. Learn about how the stock market works and why it works that way, learn the fundamentals of fundamental analysis, and take lessons from the greats that have come before you, like Warren Buffett and Benjamin Graham.

These are all practical ways to find real life results, rather than just living in theory. After all, isn’t that what this blog post was all about?