Successful Investor Today

TRUTH 1
Active Investing Is a Loser's Game: It Must Be So
Active management is a beauty contest in which the average contestant is kind of ugly.
--John Rekenthaler, Wall Street Journal


It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office.
--Paul Samuelson


We are not afraid to follow the truth wherever it may lead, nor to tolerate any error so long as reason is left free to combat it.
--Thomas Jefferson


Those whom the gods would destroy they first make active managers.
--Anonymous


There are widespread misunderstandings about asset allocation evident in its practice in portfolio management. These conceptions lead to error in its practice which would be comical, were they not so terribly costly. [Investors] shuffle their asset mix and churn portfolios in an emotional response to the markets.
--Robert D. Arnott, "Managing the Asset Mix: Decisions and Consequences," Pension Fund Investment Management




Probably the most contentious debate in the field of investing is whether active or passive management is the strategy most likely to prove to be the winning one. Believers in passivemanagement as the winning investment approach generally use the EMH (efficient markets hypothesis) as the basis of their argument. The foundation of the EMH is that efforts to outperform the market are highly unlikely to produce returns in excess of the market's overall rate of return because everything currently knowable about a company is already incorporated into the stock price, and the next piece of available information will be random as to whether it will be better or worse than the market expects. Believers in active management believe that the market is inefficient--that the market not only misprices securities, but that new information is not incorporated instantly; it is, instead, incorporated into prices slowly, over time.
The vast body of evidence clearly falls in favor of the passive management camp. It can be summarized as follows:1
• The average actively managed fund has underperformed its appropriate passive benchmark on a pretax basis by about 1.8 percent per annum. On an after-tax basis, the performance is even worse.
• There is no persistence in performance beyond that which would be randomly expected--the past performance of an individual active manager is a very poor predictor of his/her future performance.
• Expenses reduce returns on a one-for-one basis.
• Turnover reduces pretax returns by almost 1 percent of the value of the trade.
Similar evidence has been found in international markets, including the emerging markets.
While the body of evidence in favor of passive investing is powerful, no such evidence is needed to draw a conclusion asto which is likely to be the winning strategy. Active management must, in aggregate, underperform passive management--the laws of mathematics cannot be denied.2 This is true regardless of whether we are speaking of the market as a whole or a particular asset class. The reason is simple: All stocks must be owned by someone!
The Mathematics of Investing
A simple example will demonstrate conclusively that active investing, despite the claims of active investment managers, must, in aggregate, be a loser's game. The market is made up of only two types of investors, active and passive. For the purpose of this example, let's assume that 70 percent of investors are active and that 30 percent of investors are passive. (It does not matter what percentages are used, the outcome will be the same.) Let us assume that the market returns 15 percent per annum for the period in question. We know that on a preexpense basis a passive strategy (like owning Vanguard's Total Stock Market Fund) must earn 15 percent. What rate of return, before expenses, must the active managers have earned? The answer must also be 15 percent. The following equations show the math:
A = Total Stock Market, B = Active Investors,
C = Passive Investors
A = B + C
X = Rate of return earned by active investors
15% (100%) = X% (70%) + 15% (30%)
X must equal 15%
If one active investor outperforms because he overweighted the top-performing stocks, another active investor must have underperformed by underweighting those very same stocks. The investor who outperformed had to buy those winning securities from someone. Since passive investors simply buy and hold, the stock must have been sold by another active investor. In aggregate, on a preexpense basis, active investors earn the same market rate of return as do passive investors. Note that if we substituted the S&P 500 Index (or small-value stocks or REITs [real estate investment trusts] or emerging-market stocks) for the total stock market, we would come to exactly the same conclusion. It does not matter which asset class we are discussing, the math is exactly the same. The same thing is true for bull and bear markets. The math doesn't change if the bull is rampaging or the bear comes out of hibernation--active management must earn the same preexpense gross returns as passive management regardless of asset class or market condition. This is also true whether or not it is a so-called "stock-pickers' market" (there is no such thing, as you will see). Because of the investment propaganda put out by Wall Street's advertising machine and the coconspirators in the media, this is an extremely important issue for investors to understand. We will begin by examining returns in various asset classes, from the most efficient to the least. We will then turn to the issue of bear markets and the performance of active funds, and conclude with the issue of a "stock-picker's market."
The Efficiency of Markets
There has been a very persistent failure of active managers to outperform in the asset class of large-cap stocks. For example, forthe ten-year period 1982-91, only two of the seventy-one actively managed large-cap funds that even survived the period outperformed the Vanguard S&P 500 Index Fund on an after-tax and after-commission/load basis.3 With evidence like this, it is becoming harder for active managers to claim they can outperform against a large-cap benchmark. Therefore, we now often hear claims that while the large-cap market may be efficient and thus hard to outperform, the small-cap and emerging markets are not as efficient, and thus active managers can add value. Notice that in the equation (A = B + C) we used to prove active management must lose, there was no mention of market efficiency. That is because it is irrelevant whether markets are efficient or not: Active management must, in aggregate, be a loser's game simply due to greater costs.
Let's look at some of the evidence, beginning with the asset classes of small-cap stocks and small-value stocks. Using Morningstar's database, we can compare the performance of actively managed funds to appropriate passive benchmarks. The passive asset class funds of DFA (Dimensional Fund Advisors) can be used for this purpose. While the data does contain survivorship bias (making the performance of actively managed funds appear better than the reality)--poorly performing funds are made to disappear by fund sponsors--the evidence is quite revealing. For the five-year period ending December 2002, the DFA Micro Cap Fund returned 4.3 percent per annum and the DFA Small Cap Fund returned 2.0 percent per annum. All actively managed small-cap funds returned just 1.9 percent. The DFA Small Value Fund returned 4.9 percent, while actively managed small-value funds returned just 2.6 percent. And these are pretax returns. The tax inefficiency of actively managed funds in all likelihood would have made their after-tax performance look even worse.
The asset class for which the active management argument ismade most strongly is the emerging markets--an "inefficient" asset class if there ever was one. Believers in active management have one problem: There isn't any evidence to support their claim. In fact, there is substantial evidence supporting the opposite position.
The sharp drop in emerging-market equities in 1998 brought down the reputations of many emerging-market fund managers. As Richard Oppel Jr. of the New York Times put it: "Another casualty of the [emerging markets] sell-off: the widely held notion that emerging markets are fertile ground for active fund managers." 4 The year 1998 was certainly one in which active managers had plenty of opportunity to add value, either by moving to cash or by choosing the winners (South Korea +110 percent, Greece +87 percent, Thailand +27 percent, and Portugal +26 percent) and avoiding the losers (Russia-87 percent, Turkey -51 percent, Indonesia-45 percent, Mexico-38 percent, and Brazil-38 percent).5 Let's look at the facts. The 164 actively managed emerging-market funds tracked by Morningstar fell 26.9 percent in 1998, far more than the 18.2 percent loss by the Vanguard Emerging Markets Stock Index Fund, the third largest emerging-market fund. And the DFA passively managed Emerging Markets Fund fell just 9.4 percent.6
To show that 1998's poor performance by active managers was not a fluke, using the Morningstar database I examined the performance of all emerging-market funds for the nine-year period 1994-2002. The Morningstar database provides us with a list of just fourteen actively managed emerging-market funds with a nine-year track record. I then compared the performance of the actively managed funds with that of the passively managed DFA Emerging Markets Fund. (The nine-year period was chosen because that is the life of the DFA fund that we can use as a benchmark.) Even with survivorship bias in the data, the DFAfund outperformed 79 percent of the actively managed funds (all but three funds). Although the DFA Emerging Markets Fund fell 2.7 percent per annum, it outperformed the average active fund by 2 percent per annum. Only one actively managed fund beat its passive rival by more than one-half of 1 percent per annum. It is also worth noting that in addition to its Emerging Markets Fund (which is a large-cap fund), DFA also runs two other passively managed emerging-market funds, a small-cap fund and a value fund. The Emerging Markets Small Cap Fund returned a negative 0.6 percent per annum for the period, outperforming all but one fund. The Emerging Markets Value Fund returned a positive 1.4 percent per annum, outperforming all active funds. On the other hand, Fidelity's fund returned a negative 9.8 percent per annum. That is a high price to pay for belief in active management. Other well-known underachievers were the funds of Montgomery, Merrill Lynch, JPMorgan, Morgan Stanley, and Frank Russell. Consider this: If you managed to pick the top-performing fund, your belief in active management was rewarded with 3.2 percent per annum of pretax outperformance. On the other hand, if you were unlucky enough to choose Fidelity's fund, you underperformed by over 7 percent per annum. Does this sound like a game you want to play? What is perhaps most disheartening for believers in active management is that since the emerging-market returns for the entire period were negative, an active manager in this asset class would have outperformed a passive strategy by simply holding cash!
Why do active managers do so poorly in such markets? The reason is simple. There are really two issues surrounding the efficiency story. The first is information; the second is cost. And they are inversely related. For the largest cap stocks there is a great amount of liquidity in their shares. For example, using data provided by Bridge from November 8, 2001, the largest large-capstocks traded over $277 million worth of shares each day, and the bid-offer spread (an estimate of trading costs) was just 0.12 percent. Thus while the trading costs are relatively low, the high degree of information efficiency surrounding these stocks (e.g., GE, Microsoft, etc.) makes it difficult to gain a competitive advantage that can be exploited. On the other hand, in the very smallest of the small-cap stocks, the average trading volume was only around $192,000, and the bid-offer spread was 4.03 percent. 7 Thus while it may be possible to gain a competitive advantage in terms of information (because fewer analysts and traders follow these stocks), the cost of exploiting any such advantage is much greater--almost 4 percent, or over thirty times, greater.
In the "inefficient" emerging markets, while it might be possible to gain an information advantage, the trading costs incurred in trying to exploit any such advantage are huge. According to Joshua Feuerman, manager of the SSgA (State Street Global Advisors) Emerging Markets Fund, a round-trip purchase and sale of a block of stock in a typical emerging market costs about 4.5 percent of the value of the stock. "It's a disgustingly expensive asset class to trade in."8 Because turnover is much greater in actively managed funds, trading costs hit them harder than passively managed funds.
The Costs of Active Investing
The mathematical equation we began this section with to prove active investors must underperform represents preexpense, or gross returns. Unfortunately, investors don't earn gross returns; they earn returns net of expenses. To get to the net returns we must subtract all costs, including trading costs. The most obvious cost is a fund'soperating-expense ratio. According to Lipper Inc., the median stock fund's operating expense for actively managed domestic funds as of 2003, is 1.46 percent.9 This is much higher than the costs of the typical domestic index or passive asset class fund, the expense ratio of which is generally between 0.2 percent and 0.5 percent.
We have already touched on the issue of trading costs. However, it is important to note that the bid-offer spreads are just one of the trading costs incurred by a fund; commissions are another. An estimate of the negative impact of the trading (turnover) of active managers is provided by a Morningstar study. Morningstar divided mutual funds into two categories: those with an average holding period greater than five years (less than 20 percent turnover) and those with an average holding period of less than one year (turnover greater than 100 percent). Over a ten-year period, Morningstar found that low-turnover funds returned an average of 12.87 percent per annum, while high-turnover funds gained only 11.29 percent per annum on average. Trading costs and the impact on prices of trading activity reduced returns of the high-turnover funds by 1.58 percent per annum.10
One reason the trading costs of active management are so high is "market impact" costs. Market impact is what occurs when a mutual fund wants to buy or sell a large block of stock. The fund's purchases or sales will cause the stock to move beyond its current bid (lower) or offer (higher) price, increasing the cost of trading. Barra, a research organization, did an extensive study on market impact costs and found that while market impact costs will vary, depending on many factors (fund size, asset class, turnover, etc.), they can be quite substantial. Barra noted that a fairly typical case of a small- or mid-cap stock fund with $500 million in assets and an annual turnover rate of between 80 and 100 percent could lose 3 to 5 percent per annum to market impact costs--far more than the annual operating expenses of mostfunds. In another example, over a specified period the PBHG Emerging Growth Fund had the highest estimated market impact cost among small- or mid-cap funds at 5.73 percent per annum. Even large-cap funds can have large market impact costs, as illustrated by the 8.13 percent figure estimated for the Phoenix-Engemann Aggressive Growth Fund.11 Without access to the specific data it is very hard to estimate a fund's market impact costs. However, you can at least consider high turnover as an indicator of the size of the impact. In addition, the smaller the market capitalization of the stocks the fund owns, the greater the market impact cost is likely to be.
For taxable accounts, taxes are unfortunately often the greatest expense of active management. The negative impact of the burden of taxes is a result of IRS form 1099 fund distributions. Take one example. For the fifteen-year period ending June 30, 1998, the Vanguard S&P 500 Index Fund provided pretax returns of 16.9 percent per annum. The fund lost 1.9 percent per annum to taxes. Its after-tax return of 15 percent per annum meant that the fund's tax efficiency was 89 percent. The average actively managed fund provided pretax returns of 13.6 percent and after-tax returns of just 10.8 percent. Losing 2.8 percent per annum to taxes resulted in a tax efficiency of just 79 percent.12
The least understood cost, because it is hidden, is the "cost of cash." The cost of cash is a result of a mutual fund holding cash instead of being fully invested in the market. A study by Russ Wermers found that nonequity holdings reduced returns for the average actively managed equity fund by seventy basis points per annum.13 The greater the cash position held, the greater the impact.
In each of the above cases, the cost of implementing a passive strategy will be less than that of an active one. Thus, in aggregate, passive investors must earn higher net returns than do activeinvestors. The mathematical facts cannot be denied. The result of all of these excessive costs (excessive because they have not proven to add value) is that investors believing in active management as the winning strategy are leaving tens of billions of dollars a year on the table. Those billions go into the pockets of investment firms, their employees, the media, and also Uncle Sam (in the form of unnecessarily higher taxes).
As stated earlier, the math of active management applies to all markets, including bear markets. Because behaviorists have found that for investors the pain of a loss is about twice as keenly felt as the good feelings generated by an equivalent gain, bear markets are when the claimed protective value of active management is needed most. Let's now examine the historical evidence of active managers in bear markets.
Active Management and Bear Markets
Theoretically anticipating bear markets, active managers can reduce their exposure to equities and protect their investors from the type of losses that index funds experience (since index funds are always virtually 100 percent invested). However, keep in mind that whenever a stock is sold, there is another buyer somewhere--all stocks must be owned by someone. Since passive investors are not altering their positions based on anticipated market conditions, if an active fund is a seller, in general another active fund is the buyer.
Let's look at the historical record to see if active managers actually provided the protection they claim they provide in bear markets.
• Just prior to the second worst (at the time it was the worst) bear market in the postwar era (1973-74), mutual fund cash reserves stood at only 4 percent. Cash positions reached about 12 percent at the ensuing low.
• In mid-1998, when the "Asian Contagion" bear market arrived, cash reserves were just 5 percent. Compare this to the 13 percent level reached at the market low in 1990, just prior to beginning the longest bull market in history.14
• During the bear market of 2000-01, cash reserves of actively managed mutual funds fell to an average of just 1.35 percent. In other words, they were basically fully invested at the worst time.15
It seems fund managers are very good at executing a buy high and sell low strategy.
A Lipper Analytical Services study provided further evidence on the failure of active managers to outperform in bear markets. Lipper studied the six market corrections (defined as a drop of at least 10 percent) from August 31, 1978, to October 11, 1990, and found that while the average loss for the S&P was 15.12 percent, the average loss for large-cap growth funds was 17.04 percent.16
Fund managers fared no better in the bear market of July-August 1998. During the decline between July 16 and August 31, the average equity fund lost 22.2 percent. This compares to losses of just 20.7 percent and 19.0 percent for a Wilshire 5000 Index fund and an S&P 500 Index fund, respectively.17 Susan Dziubinski, editor of Morningstar's FundInvestor newsletter, put it this way: "The average fund can't keep up with its index when it's sunny or rainy."18
And finally, consider this evidence. Goldman Sachs studied mutual fund cash holdings from 1970 to 1989. The study foundthat mutual fund managers miscalled all nine major turning points.19
It is worth noting that the commercial success of indexing among institutional investors began in 1975 (a fund was built for New York Telephone's pension plan). The poor performance of most active managers during the bear market of 1973-74, the second worst since the 1930s, revealed just how hollow is their claim that their "expertise" in protecting capital is most valuable in difficult markets. While it may be coincidence, I suspect that the motivation to adopt indexed strategies was partly attributable to disappointment with the traditional active management approach, which failed to deliver when it was most needed. Let's now turn to examining the issue of "it's a stock-pickers' market."
It's a Stock-Pickers' Market
In 2000, 63 percent of active managers outperformed the S&P 500 Index. Active managers immediately declared that it was once again a stock-pickers' market and that active management would prove to be the winning strategy. Unfortunately, this is an old canard that is trotted out every so often in an attempt to both keep alive the myth that active management is the winning strategy and to keep investors paying high fees for poor, inconsistent, and tax-inefficient performance. However, when the proper light is shed on the subject, the canard is exposed.
Active managers point to their successes in years like 1977-79, when 85, 69, and 80 percent, respectively, of the actively managed funds outperformed the S&P 500, and 1991-93 when 55, 54, and 60 percent, respectively, did so, as "proof" of their ability to outperform the market. The claim is that those were stock-pickers'kind of years--as opposed to the years 1994-98 when no more than 22 percent of the active funds accomplished that feat. The problem with the claim of it being a stock-pickers' market is that it doesn't hold up to scrutiny. The reason is that the "defendants" are using an apples-to-oranges argument to make their case. The conclusions are drawn because of confusing indexing (or, more broadly, passive investing) with the exclusive use of the S&P 500.
For the twenty-eight-year period 1975 through 2002, there were eleven years when large-cap stocks outperformed small-cap stocks. In each of those eleven years fewer than 50 percent of the active managers beat the S&P 500 Index. In fact, in only one of those periods did more than 26 percent of the active managers outperform the S&P 500 Index. The one exception was 1990, when just 36 percent of the active managers beat that index.20 In most years when small-cap stocks outperform large-cap stocks, a majority of active funds will generally outperform. The explanation for the seeming outperformance of active managers in those years is that the typical actively managed fund holds, on average, stocks with a smaller market cap than the weighted-average market cap of the S&P 500 Index. One obvious example of this is small-cap funds. Small-cap funds should be expected to outperform a large-cap index when small-cap stocks outperform. This, however, would have nothing to do with stock selection and everything to do with asset allocation. And it is asset allocation, not stock selection or market timing, that determines almost all returns. The S&P 500 Index is, therefore, not the correct benchmark for all actively managed funds. Actively managed funds should always be benchmarked in a way that ensures an apples-to-apples comparison.
Another explanation for the "outperformance" of active managers in 2000 is that value funds outperformed growth funds (like the S&P 500). Thus any actively managed value fund, or even anactively managed growth fund that had more exposure to the value asset class than does the S&P 500 Index, was highly likely to outperform that particular benchmark. For example, while the S&P 500 fell just over 9 percent, the DFA Large Value and Small Value Funds both rose more than 10 percent. Those funds would be more appropriate benchmarks for value-oriented funds than would the S&P 500 Index.
To gain further perspective on whether or not active management is the winner's game, let's take a longer term look at the performance against two benchmarks, the Wilshire 5000 and the Russell 3000, which are broader indices than the S&P 500 Index. For the five-, ten-, and fifteen-year periods ending in 2000, only 16, 16, and 17 percent, respectively, of actively managed funds outperformed the Wilshire 5000, and only 14, 14, and 15 percent, respectively, of actively managed funds outperformed the Russell 3000.21
Does Indexing Affect Stock Prices?
The S&P 500 Index returned almost 29 percent per annum in the second half of the 1990s, the greatest five-year run in history. This led to S&P 500 Index funds becoming villains of an investment soap opera. Active managers were blaming their underperformance on S&P 500 Index funds. The theory goes like this: Money pours into the index funds because of the dissatisfaction with the underperformance of active managers; the funds "blindly" buy the large-cap stocks and drive the market ever higher.
The problem is that this theory is based on a false premise, as Melissa Brown demonstrated in 1998. Brown, then head of quantitative research at Prudential Securities, found that while S&P500 Index funds had grown in assets from $255 billion at the end of 1992 to $600 billion at the end of 1997, they represented only 6.1 percent of all stocks by the end of 1997, down from 6.7 percent at the end of 1992. Brown pointed out that since the total return (price appreciation plus dividends) of the S&P 500 Index was 152 percent, all of the gain in the amount of S&P 500 indexed assets was a result of price appreciation, not cash inflow. In fact, if the amount of funds in S&P 500 Index funds had grown as much as the 152 percent total return of the index itself, the amount of money invested in these funds would have grown to almost $650 billion. This is $50 billion more than they actually held. This indicates there were actually net cash outflows from these funds. This clearly suggests that the underperformance of active managers is not due to inflows into index funds.22
It is important to note that the net cash outflow from S&P 500 Index funds during this period should not be taken as an indication that investors were decreasing their commitment to passive investing. In fact, the contrary was true. Not all index funds are tied to the S&P 500. In recent years, index funds have been created to replicate the performance of the Russell 2000, the S&P/Barra Value Index, the EAFE (Europe, Australasia, and the Far East) Index, and many others. When all passive funds are considered, their market share was growing at a rapid pace.
Burton Malkiel and Aleksander Radisich took another look at the claim that indexing influences security prices.23 Their study, "The Growth of Index Funds and the Pricing of Equity Securities," tested three hypotheses:
1. Index funds will tend to increase their advantage over actively managed funds during periods when the market rises.
2. S&P 500 Index funds will tend to increase their advantage over actively managed funds during periods when large-cap stocks outperform smaller firms.
3. S&P 500 Index funds will increase their advantage as the proportion of fund inflows into index funds increases.
The first hypothesis is logical in that in rising markets index funds have the advantage of always being virtually fully invested while actively managed funds typically carry cash positions of as much as 5 to 10 percent or more--for liquidity and trading purposes. The study found that the hypothesis is correct in that the excess performance of indexing increases when the market is rising. The t-stat, a measure of statistical significance, was very high at 4.9 (with 2.0 considered the hurdle for significance as it provides 95 percent confidence that the result was not a random outcome). It is important to remember that indexing has outperformed in bear markets as well. Thus while the size of the outperformance shrinks in bear markets, it never disappears.
The second hypothesis that S&P 500 Index funds will tend to increase their advantage over actively managed funds during periods when large-cap stocks outperform smaller firms is also logical in that not all actively managed funds hold only large-cap stocks, as does the S&P 500. As we discussed, in periods like 1977-79 and 1991-93, when small-cap stocks outperformed large-cap stocks, we should expect that not only will small-cap funds outperform a large-cap index fund but that some large-cap funds will also do so (as many are not style pure, holding smaller cap stocks than are in the S&P 500 Index). The study confirmed this hypothesis as well: When small companies outperform, theadvantage of indexing large-cap stocks shrinks. The t-stat again was very significant at a negative 3.2.
The third hypothesis that indexing influences prices is, however, rejected. They found that the flow of money into index funds was totally unrelated to the excess performance of index funds. Thus there is no support at all to the claim that the success of indexing has been self-fulfilling.
The authors also studied the impact of a stock's entry into the S&P 500 Index. There have been studies showing that a stock's entry bolsters demand and on average increases the price of the stock. The study examined the price action of all stocks entering the S&P 500 Index between July 1980 and July 1999. The authors found that while there is a statistically significant postentry "pop" lasting about one week, the excess performance is essentially reversed over the following year. This contradicts the notion that there is any permanent price impact for stocks that enter an index.
The authors also made another important observation that demonstrates the false nature of the claims that indexing influences prices and was responsible for the failure of active managers in the late 1990s. They note that the superior performance of the S&P 500 Index during this period was driven mostly by the returns of the very largest stocks in the index--the performance of the top 50 far surpassed the performance of the remaining 450. Because indexing purchases a proportional share (based on market capitalization) of each stock, it cannot be responsible for the outperformance of the top 50. Thus it must have been the actions of active managers who were, in fact, driving returns.
The evidence and the logic is that indexing does not drive prices. The advantage of indexing is based solely on the mathematics of investing: Despite this logic, there are two things of which we can be sure: The first is that the next time small capsoutperform large caps we will hear once again that "it is a stock-pickers' market." Nothing of course could be further from the truth. It is simply an issue of understanding what is the proper benchmark to use. Small-cap fund managers, while outperforming the S&P 500 Index, will be underperforming the index against which they should always be benchmarked, the S&P 600 Index (a small-cap index). The second is that in periods when large-cap stocks outperform (thus the S&P 500 Index will outperform the majority of active managers), the marketing machines of Wall Street will find a different excuse for their poor performance. Passive investing is the winner's game in all markets; the math dictates that it must be so.
The Triumph of Hope over Experience (and Wisdom)
Steve Galbraith teaches security analysis at Columbia University in its M.B.A. program. He is chief investment officer at Morgan Stanley and a coauthor of Morgan Stanley's US Economic Perspectives. In March 2002, Galbraith invited John Bogle, the former chairman of the Vanguard Group and a strong advocate of passive investing, to speak to his class.
In the April 3, 2002, issue, Galbraith related the following about Bogle's presentation. "He laid out the case against active management and for indexing quite powerfully. My guess is that more than a few students left the class wondering just what the heck their hard-earned tuition dollars were doing going to a class devoted to the seemingly impossible--analyzing securities to achieve better-than-market returns." He added: "At least the studentshave the excuse of being early in their careers; what's mine for staying the course in my current role?" He also admitted: "We recognize that the odds are against active managers."
Galbraith went on to point out that the actual returns to investors in the greatest bull market ever ranged "from the subprime to the ridiculous." He also wondered what will happen now that returns are more likely to be in the neighborhood of just 7 to 8 percent, instead of the almost 18 percent per annum returns the S&P 500 provided in the twenty years from 1980 through 1999.
Galbraith closed his letter to investors on a very revealing note: "From our perspective, perhaps in a triumph of hope over experience, we continue to believe active managers can add value." Another perspective might be that, given the role of his employer, to believe otherwise would be committing economic suicide. The winning strategy for investors is simply to accept market returns. Unfortunately, that is not the winning strategy for Morgan Stanley in terms of profits. While active management does offer the potential for greater than market returns, it is far more likely that investors will end up with below benchmark returns. This is why Charles Ellis called active management the loser's game. The odds of winning are so low that a prudent investor would choose not to play--unless he or she placed a high entertainment value on the effort.
Active Management Is the Loser's Game
Does the math of investing mean that investors in actively managed funds are doomed to underperform? If we are talking as a group, the answer is a resounding yes. Does this mean that all active managers will underperform? No. In fact, given the thousands of fund managers (and individuals) playing the "game,"randomly we would expect some to win. However, if outperformance was random, the number succeeding should not only be no greater than would be randomly expected but the number succeeding should decline as the investment horizon increases. The reason is that the burden of expenses increases over time due to compounding, making the task more difficult. The evidence, as can be seen in the chart below, is that the performance of active managers looks very much random in nature. The number of outperformers declines over time, and the graph shows performance to be to the left (underperformance) of the normal bell curve.
The only question then left for believers in active management is whether or not an investor can identify ahead of time the very few active managers who will outperform their passive benchmark. It is, of course, an easy job to do so on an ex-post basis. The question is, how likely is it that one can accomplish this objective on an ex-ante basis. This is the issue we will explore in our next section.

THE SUCCESSFUL INVESTOR TODAY. Copyright © 2003 by Larry E. Swedroe. All rights reserved. . No part of this book may be used or reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles or reviews. For information, address St. Martin's Press, 175 Fifth Avenue, New York, N.Y. 10010.