Follow up to the Defense of Actively Managed Mutual Funds

First of all, I was thrilled to see a very thorough response to my story from Jeff Ptak.  I admittedly have not read a lot of his stuff outside of recent twitter postings, but I certainly will from now on.  To catch everyone up who may just be tuning in:

Ben Carlson posted an article on his great blog, A Wealth of Common Sense, using data published by Jeff.  Its titled “Uncle Sam Loves Active Mutual Funds” and can be found here.

I took some issue with a few of the assumptions made on the study, so I wrote a rebuttal, which can be found here.

Jeff then wrote an excellent defense of his methods and assumptions in a follow up, found here.

I only have a few things to continue this discussion.  First of all, Jeff is right in that he and I are not far off philosophically in terms of the active/passive investment discussion.  We both acknowledge that beating the market is hard, and trying to do so in a mutual fund structure after tax, while also collecting a fee is extremely hard.  I do think we differ on the degree.  His data shows that a tiny fraction of funds across asset classes will beat their respective index over a ten-year period.  My article questioned the severity of the assumptions used in that data and argued that the active fund managers were not getting a fair shake.

To start, I am confused by the contention that oldest surviving shareclass is actually cheaper than the universe as a whole.  Here is the excerpt from his post:

On 4, I disagree with Keith’s assertion that ‘oldest shareclass’ funds are most often the expensive shareclass. To put this in perspective, when I run a screen today for all US equity funds and limit to oldest shareclass, the average expense ratio is 1.07%. When I don’t limit to oldest shareclass, the average expense ratio is 1.18%. Granted, this is based on today’s expense ratios, not those that prevailed ten years ago. But if anything I would expect the oldest-shareclass method to have been more friendly to active funds if I’d run it as of 10/31/05 given that it would have screened out many expensive load shareclasses (which were far more abundant at that time vs. today).

The Morningstar screener says that this shareclass is “usually, but not always, the A share.”  As I mentioned, the funds I examined all had the A share as the most expensive variety to the tune of about 0.25%.  I don’t doubt Jeff’s assertions, but I just need some clarification.  Either way, I said the disadvantage in the small-cap growth space appeared to be about 0.25%.  Jeff said that even if you gave the funds the 0.25% back it would not materially change the outlook.  He posted the following graph to explain.

avg beat and lag

I appreciate data on the average fund performance shown against average beat and average lag.  For the sub-sample I worked on, (small-cap growth) it appears that the average fund underperformed the index by around 1.2%.  This actually shows that there is some collective investment acumen being displayed since the average fee is around 1.4%.  While the 0.25% in fee difference does not make the group go from collective losers to collective winners, I only wanted to show that there are some funds that rest on the bubble and would make the jump if judged on their more favorable share class.  This fee difference would merely improve the number of beats, even if not change the overall dynamic of “most funds do not beat”

As for the treatment of taxes, I indicated that applying the highest marginal rate across the board was too harsh of an assumption to make.  Jeff accepted that that was “fair” but that some of my analysis was “self-contradictory”.  My suggestion here is just that the investors who are subject to the highest marginal rate have incomes over $464,000 (if married-filing-jointly).  These investors should hopefully be getting some advice if they are pulling in that kind of money and able to access the cheaper expense share classes with higher minimums. They should also not be blindly buying, holding, and then selling with no regard to the tax implications.  For the average retail investor, working as an assistant manager somewhere making $75,000, they would not be subject to this highest marginal rate.  Therefore, our “average” investor would fall somewhere below the highest marginal rate.

The question about dead funds is a tough one.  I will concede that most funds die due to underperformance and deserve to be labeled as laggards; however, that is not the only cause of death and therefore, I feel it is still too punitive to lump all non-survivors in that category.  For instance, here is a link to a story about how Amcore Bank, (getting close to the end of the real estate boom and needing to raise cash), sold three of its mutual funds to Federated Investors.

I have no idea if the funds were laggards or not, and the assets were merged into existing Federated funds.  My arguments are that cases like this do exist, and that the investor experience is very hard to measure.  Seeing as how the ten-year period of the study starts in 2005, you could see a lot of companies that failed in 2008 and took their mutual fund operation with them.

I will end by saying, I think that for the majority of retail investors, putting the bulk of your investable assets into low cost index funds is a great way to go.  I prefer to think of active investment management, (my own as well as that being outsourced to mutual fund managers) not so much as an investment expected to “beat the market”, but really as a way to more carefully manage the risk/return profile of a pool of assets.  Case in point was 2009.  There were stocks in the S&P 500 which I would not have touched with a 40-foot pole.  There was a real question on whether some of those companies were going to survive.  When those financially troubled stocks ended up avoiding bankruptcy, they rebounded dramatically.  I would prefer to avoid the risk that those companies fail even if it means not capturing the upside if and when they ultimately survive.  We are seeing the same thing now.  There is no way I would own a high-yield bond index like HYG right now.  I would much rather own a fund managed by someone I can call and ask, “what is your exposure to the financially troubled energy sector right now?”  When you manage a portfolio of assets, each piece has its place and sometimes actively managed mutual funds are the best way to go.  (I can get into a discussion about core – satellite investing in another post).

Any rigorous academic study in the realm of finance needs to apply a set of assumptions in order to turn the mass amounts of data into useable information.  No matter what assumptions are applied, there will be some who disagree.  I would apply different assumptions than those Jeff used in the study, but I certainly respect his process and thoughts on the matter.

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