HE DEBATE HAS RAGED FOR YEARS, which is superior: active management or basic indexing. Each style has its advocates and both point to historic results to support their position.

Major mutual fund companies offering funds that track market indexes sing the praises of passive indexing. Not surprisingly, brokers and hedge fund managers recommend their styles of active management. Both groups obviously have a vested interest in their respective sides of the argument.

But self interest aside, this is a real and meaningful issue. It's often cast as debate about the "Efficient Market Theory".

The strongest versions of this theory hold that all relevant (with the possible exception of inside) information is quickly and efficiently reflected in the market. If true, any attempt to "beat" the market will be doomed to fail since it would be impossible to have and act on material information not already incorporated in share prices.

Active management, by definition, is an attempt to beat the market. You wouldn't be willing to pay someone to manage your money unless you thought he or she would at least have a fighting chance to outperform an unmanaged index. If you didn't think they could, you'd be better off saving the management fee and sticking with the index.

Indexing came into its own in the 1990s. With the increased use of efficient trading techniques and futures contracts, index managers are now able to almost totally eliminate tracking error versus their benchmark indexes. Also in the 1990s, major indexes handily defeated the majority of active managers.

But over the past several years, more and more active managers have once again outperformed passive indexes. Is the market suddenly less efficient?

Time Tells

This is a dramatic improvement from the 5-year period ending November 2002 (37% outperforming) as well as the 10-year period (30%). Are active managers becoming more talented?

As nice as that would be, there is however, another explanation. Think about what's happened in the market in the past three years when the majority of active managers outperformed the index: One of the longest bear markets has reduced the S&P 500 to an annual loss of 11.13%.

Get the Picture?

Source: A-T Financial The worse the index does, the better active managers' relative performance. There's a reason behind this, and it's not greater skill in down markets.

Now think about the market over the 5-year period when almost 2/3 of active managers underperformed: This includes the final two years of the long-running bull market when the largest of the large stocks were market leaders. Over this period -- three bear years and two bull years -- the S&P had an annualized return of 0.97%.

Finally, over the 10-year period there were seven bull years and three bear years. Large company stocks dominated the markets and the S&P 500 produced an annualized return of 10.14%.

The nearby chart compares the return of the S&P 500 to the percentage of active managers outperforming the index. What jumps off the chart is the fact that the better the index does, the fewer active managers outperform. Conversely, when the index does poorly, more active managers outperform.

When the index was leading the market up in the 1990s, the only way managers could beat it was to deftly pick stocks that not only would go up, but go up more than the index. In essence, the only way to outperform was to consistently demonstrate superior stock picking abilities.

But in the recent past when the S&P 500 was not only down, it was trailing smaller cap indexes, there were a number of ways to beat it. The obvious way was to hold small or mid cap stocks. This is a pretty standard practice that we've highlighted before when we pointed out The Name Doesn't Tell It All.

Better yet, cash or bonds actually had positive returns. Many mutual fund prospectuses are so loosely written, "large cap" managers could actually hold bonds.

Those that didn't raised cash levels. While money market yields are currently next to nothing, at least they weren't negative -- and severely so -- like the returns on stocks.

And therein lies active management's dirty little secret: Active managers do the best when they don't do what they claim to. Most outperformance doesn't come from superior stock picking but rather from gaming the index.

When the benchmark index is leading the market as it was for large cap managers in the 1990s, few can beat it. When the benchmark is trailing others, many more active managers outperform by simply holding something else.

While you'd always want your manager to do as well as possible, if you've built a portfolio through asset allocation, you'd also want your active managers to fill those slots they're supposed to. Unfortunately, they do their best when they don't.

Someone's Still Listening

"And every word is nonsense but I understand."

-- Counting Crows Anna Begins

 

AST YEAR HAD MORE THAN ITS share of scandals. Corporate shenanigans dominated the early part of 2002 while the games played with sell-side research were highlighted at year-end.

The depth and number of corporate scandals came as quite a surprise to most investors. In the back of everyone's mind was the belief that corporate disclosure in the U.S. was head and shoulders above that in other countries. Until last year, there had been a lot of (misplaced) trust in the work of the SEC.

But there wasn't such confidence in sell-side research. Even back in the 1990s when analysts only used "buy" and "strong buy" ratings, everyone knew that was an overstatement. Everyone knew sell-side analysts were at least partially compensated by the underwriting fees they brought in. Everyone knew wouldn't put a "sell" or even "market perform" rating on a stock of a company their firm worked with.

So it's a little surprising that investigations into Merrill Lynch and Salomon Smith Barney have had such an impact or received so much press. As the disclosures from Merrill confirmed, analysts really didn't believe all the positive hype they were putting out. But didn't everyone know that -- or at least strongly suspect it?

Similarly, it shouldn't have taken the Salomon probe to prove that sell-side analysts had other interests in mind when they wrote their glowing buy recommendations on every stock they covered. Everyone knew -- or should have known that, too.

Not What But Who

We know sell-side analysts continue have an impact since their calls still move individual stocks. The accompanying chart shows nine such instances from mid-November to mid-December 2002.

For each stock we show the day of the analysts' call, the stock's one-day change and that of the S&P 500 index. We also list the firm making the call and the reason they gave for it. There was no other company-specific news on any of these stocks on the days listed.

The stocks represent a wide cross-section of the market. We've included upgrades as well as downgrades. All are large caps so the S&P 500 is an appropriate benchmark.

The first thing to notice is that on the day of the call, each of the stocks had a disproportionate move relative to the market. It didn't matter whether the call was an upgrade or a downgrade. When the analysts spoke, someone obviously listened.

Perhaps the most surprising thing, though, is who did the listening. How many Mom and Pop retail investors buying 100 or 200 shares at a time do you think it would take to move these large cap stocks as much as shown on the chart? Without help from big institutional investors, it would never happen.

Truth be known, such large moves can only occur when institutional investors buy or sell thousands of shares at a time. In most instances, by the time Mom and Pop find out about the analyst call, institutional investors have already traded on it.

And that's what's odd. Aren't institutional investors supposed to be the most savvy out there? Aren't they supposed to be surrounded by crack research staffs and not so dependent on sell-side analysts? What's up with that?

The very investors who shouldn't have been fooled by sell-side analysts are still listening to them. These are the folks managing equity mutual funds and collecting well over 1% in management fees per year to do so.

If you know better than to rely on sell-side analysts, why doesn't your fund manager? Gives you something to think about in the New Year, doesn't it?

E-mail your comments.

Search this site! Just enter you key word or words:

 

Get current quotes or follow your own custom portfolio, courtesy of E-Line Financials:
 

Search:TickerName Company DataQuickQuote

 

Homepage

Return to Top