Active Management: Ferri’s Five Negative Strikes

When I began investing there were no index funds.  The number of mutual funds numbered fewer than 300 and fund research was conducted by going to the library and requesting Weisenberger Mutual Fund Reports.  Mutual funds have multiplied like fruit flies and there are now well over 10,000.  Do we need this many?  Likely not.

Let's look back 35 years to when there were approximately 260 actively managed domestic equity mutual funds available to investors.  This is about the time the Vanguard 500 Index Fund was launched.  Of those 260 funds approximately half merged or closed leaving 136 surviving in 2009.

Examining the performance from 1984 through the end of 2009, the Vanguard 500 Index Fund placed in the 34th percentile of surviving funds.  This data comes from Lipper.  Quoting Richard A. Ferri from his book, "The Power of Passive Investing," "Exactly one-third of the surviving funds outperformed the index fund and two-thirds underperformed.  This win-loss ration of 1 to 2 is right in line with what all the academic studies from the 1960s and 1970s predicted, showing that passively managed index funds do perform as expected."  Keep in mind that the closed and merged funds where not included in the 25-year study, although additional research did account for the survivorship bias.  Again quoting Ferri, "Without survivorship bias the Vanguard 500 Index Fund beat over 85 percent of actively managed funds during the 25 year period."

1. Strike one against actively managed mutual funds is that they do not significantly outperform the index.

2. Strike two is that those that do beat the index do so by a very small percentage.  Back to Ferri.  "The winning funds won by an average of 0.96 percent, while the losing active funds fell short by 1.69 percent on average."  The winning percentage is too low considering the probability of picking a losing fund vs. picking a winning fund.

3. Strike three is the sales load fee.  Most of the early mutual funds carried a load of 8.5%.  One had to search for no-load funds in the early days of mutual funds.  If loads figured into the calculations for the 25-year study, only 12% of the active funds would top the index fund.  Those are odds one should not go against.

4.Strike four, according to Ferri, is risk.  Most of the actively managed funds that outperformed the index fund did so by taking on the added risk of investing in smaller-cap stocks.  Peter Lynch exposed himself to additional risk by going into the international market when he was managing the Magellan Fund.

5. Strike five is taxes.  Index funds are inherently tax efficient compared to actively managed funds because index funds do not turn over securities on a regular basis.  Index ETFs are even more efficient.  Taxes are not the issue in tax deferred portfolios, but they can be a significant factor in taxable accounts.

Ferri estimates that the Vanguard 500 Index Fund beat over 90% of the actively managed mutual funds over the 25-year period.


TLH Spreadsheet Audio Clips

To accurately track and monitor the performance of your portfolio, as well as several benchmarks, I highly recommend each investor seriously consider learning how to implement the Thomas-Lalla-Herr (TLH) spreadsheet.  Below are a number of audio/video help sessions that will answer many of your questions.  If you are still puzzled, post issues in the Comments section of any blog entry and I will pick them up.  If necessary, I will create a new audio/video clip to answer the question.

I recommend starting with a simple TLH spreadsheet such as the Kenilworth SS.  This SS has few entries yet contains all the worksheets.

To gain access to these help clips, become a Platinum member at $5.00 per month.

1. Overview of the TLH spreadsheet.

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