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Is Using Active Investment Management a Fiduciary Breach? - Part Two

Updated: Jan 1, 2020

In our first post in this series, we acknowledged the compelling force of the theoretical and empirical evidence leading to provisionally answering “yes” to the question “Is using active investment management a fiduciary breach?”

We then observed that these same forceful advocates acknowledge that some active managers can, in fact, outperform both their benchmarks and their passive/index fund managing colleagues.

We want to explore the claim that superior active managers can be identified. We also want to understand ways that active managers should evaluated over time. In this and subsequent posts, we will do just that.

The first principle in active manager selection isn’t what you may think.

The first principle in picking active investment management is not choosing the manager or group of managers that will outperform in the future. It is reducing your chances of picking those who will only perform as well as passive (index) strategies or, worse, those who will underperform.

Despite a strongly held (and, at times, vigorously asserted) belief among investors – as well as most of the financial services industry - despite its disclaimer - that past excess returns do imply a likelihood of a repeat in the future, our research and experience indicates the opposite: The most appropriate method of selecting active investment managers is defensive. That is, a risk minimization approach.


In the past year, two of the largest mutual fund managers have published studies that:

  • Acknowledge that, on average, large cap U.S. equity fund managers have been unable to outperform either their benchmarks or their low-cost passive peers;

  • Argue that they have identified “straightforward criteria” for identifying “a class of active managers [who] have delivered greater excess return” than either their active peers or their benchmarks and passive alternatives.[1]

Each study identifies two characteristics (“signposts”) that appear to help identify active managers who have achieved superior performance through multiple market cycles over meaningful periods of time.

Although one signpost, low fees, is affirmed by both (both studies identified the least expensive quartile of large cap domestic equity fund expense ratios as their low fee group), each study also identified a different, additional signpost:

Large assets under management (or scale) (Fidelity)

High manager ownership of the fund (American Funds)

While we acknowledge there may be some special pleading involved in these studies, we also think the claims are interesting enough to consider further. Taken together they claim that it may be relatively easy to narrow the universe of active investment managers to a sub-group less likely to underperform.

Believing, as John Adams did, that “facts are stubborn things”, we decided to test their findings using a slightly different approach that, we think, can be easily replicated by individuals or investment advisors using readily available and affordable resources. We relied solely on data from Morningstar’s Advisor Workstation and eVestment Alliance for this analysis.

Since both of the studies encompass large cap domestic equity managers, we limited our test to that category. We decided to start our analysis with funds with histories going back at least 30 years to January 1, 1986. We evaluated 11 periods (1986-2015, 1987-2015, etc.) using the growth of $100 as our measurement of out- or under-performance versus both the Russell 1000 and the S&P 500.  Growth of $100 isn’t the only data point we considered. We elected to use it because, unlike average annual return or even cumulative return, it clearly accounts for the impacts of superior (or inferior) performance in various periods because the ending value incorporates them by definition.

We did not try to account for survivorship bias as the studies had. Our reasoning here was twofold: First, the databases that meet our “readily available” and “affordable” criteria do not include funds that have closed or merged. Second, given that we were using very long measurement periods ranging from 20-30 years we thought the mere fact of survival might be an indicator of superior skill. That is if, as many studies indicate, really poor funds cease to exist in very significant numbers then our universe might, by definition, be of higher quality stuff.

Our initial universe included 76 funds. Using only the “scale” criterion, we found the following results:

  • 44 (58%) outperformed the S&P 500 in at least one of the periods

  • 38 (50%) outperformed the Russell 1000 in at least one of the periods

  • 13 (17%) outperformed the S&P 500 in all 11 periods

  • 11 (14%) outperformed the Russell 1000 in all 11 periods

  • 28 (37%) outperformed the S&P 500 in at least 7, or 64%, of the periods

  • 23 (30%) outperformed the Russell 1000 in at least 7 of the periods

Not, in our view, compelling results, especially considering that the threshold of 7-of-11 periods represents only a 64% score, the equivalent of a D-. If we set the threshold at 80%, only 21 funds (28%) exceed the S&P 500’s cumulative return; only 16 (21%) that of the Russell 1000.

Based on this analysis we do not find “scale,” or the size of the mutual fund complex, a particularly strong indicator of index-beating performance. In our next post in this series, we’ll report the surprising results of applying the “manager ownership” criterion. Stay tuned!

Ed Lynch is founder and CEO of FPG. He has worked with ERISA-qualified plan sponsors and designated fiduciaries in most aspects of plan development and maintenance since the early 1980s. Ed founded FPG with the mission to be a leader in the field of employee benefits and the most trusted source of information and evaluation in the retirement plan industry.

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