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Is Active Investing Performance-Chasing?

Posted: Nov. 6th, 2010  |  By Forbes

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In investing, "performance-chasing" is buying something after it's had a nice run up. And when we look at the data showing flows into and out of mutual funds, the statistics clearly show that investors plow money into hot funds and bail out of the previously hot funds once they cool down and lose their luster. And we know that this pattern of buying high and selling low is a recipe for financial disaster.

But when we stop and think about active investing, even at the very basic level of selecting funds, doesn't that also fit the definition of performance-chasing? We know that most active investors don't simply buy any old active fund; they look at past performance and buy the funds that have enjoyed a nice run up. I don't recall a single active investor stating that they look for funds with poor or even average track records to invest in. We understand that active investors are searching for those funds that they think will outperform the market, but sadly, that's usually done by looking in the rear view mirror at how the funds they're considering have performed in the past and projecting that same great performance into the future. Greg Baer and Gary Gensler, authors of The Great Mutual Fund Trap, noted that of the 50 top-performing funds in 2000, not a single one appeared on the list in either 1999 or 1998.

And there's this telling statistic. According to Morningstar (nasdaq: MORN - news - people ), four-star- and five-star-rated funds captured about 72% of the roughly $2 trillion of net inflows into all funds with star ratings over the decade through Dec. 21, 2009.

In doing research for his forthcoming book The Power of Passive Investing, author Richard Ferri conducted a study that validated earlier work done by author and columnist Allan Roth. Both came to similar conclusions and reported the overwhelming odds against an active investor being able to pick a long-term portfolio of active funds that would outperform their index fund counterparts.

Rick reported some of these in two earlier Forbes.com columns, titled "Active Management Is Uncompensated Risk" and "A Winning Fund Doesn't Equal A Winning Portfolio."

And yet, despite the overwhelming odds against succeeding in selecting winning funds and building an active portfolio that will outperform over the long term, active proponents still think they can defy the odds.

In the oft-repeated and long, heated discussions on the topic of active vs. passive on some of the investing forums, you'd think we were in Lake Wobegon--all of the active proponents seem to think they're above average.

Here's what Jack Bogle had to say about that in a recent interview:

We all think we're smarter than average, better drivers than average. I've observed without factual verification that most people think they're better lovers than average, and they think they're better managers, because "I can pick good managers." The record is bereft of a single scintilla of evidence that's an easy thing to do. In fact French and Fama in their most recent publication just a few weeks ago said the chances that a mutual fund will beat the market over a long period of years is 3%. The odds are 97% that you'll do worse than in an index fund. So I'd just like to bring common sense, reality and mathematical truth back into the world of investing. And don't think I'm going to stop trying.

The active investors claim that it's easy to pick winning active funds and say they're living proof, since they claim to have done it for years. They further state that they can somehow easily eliminate 80% of the active "mutt fund" choices from the pool of funds under consideration.

They then trot out the names of some active funds that have actually outperformed as "proof" but, not surprisingly, few (if any) admit to having owned any of the vast number of underperforming funds. And they also don't admit that they may well have bought the winning active fund after it had enjoyed its nice run up in net asset value. Again, the studies show that investors actually underperform the very funds they own, because of performance-chasing. In fairness, we need to point out that performance-chasing isn't limited to active investors, but they're probably responsible for the majority of it, because indexers tend to be primarily buy-and-hold types.

In forum discussions my usual reply to the active investing proponents is to ask them this simple question: "If it's so easy to pick winning funds, as they claim, could they please tell me who owns all of those underperforming active funds that garner billions of dollars from millions of investors?" The usual reply is that those funds are owned by dumb, unsophisticated investors and not by them. Again, we see the Lake Wobegon effect.

Bill Schultheis, advisor and author of The Coffeehouse Investor, probably said it best: "Using past performance numbers as a method for choosing mutual funds is such a lousy idea that mutual fund companies are required by law to tell you it is a lousy idea."

Excluding those investors whose only choices in their retirement plans are active funds, it could probably be argued that nearly all other active investing is a form of performance-chasing.

Yet despite the overwhelming odds against success, the active vs. passive debate rages on as active investors continue to search for the Holy Grail. Hope springs eternal!

Mel Lindauer, CFS, WMS, is one of the founders of the Bogleheads community and co-author of The Bogleheads' Guide to Investing, along with Taylor Larimore and Michael LeBoeuf. He is also co-author of The Bogleheads' Guide to Retirement Planning, along with Taylor Larimore, Richard Ferri and Laura Dogu.

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