Sept. 7 2010 Tuesday 11:47
 
 
Passive Management of portfolios is superior to active management
Remember the goal of active portfolio management is to beat the market.  In order to accomplish this feat they must do so through market timing and security selection.  However, the result is that 85% of the time active managers fail to meet or beat their respective bogeys and only succeed in generating higher fees and trading costs, and increased taxes due to turnover.  Got that?  Underperformance and higher fees!  You may ask, why not choose the 15% who actually succeed in beating the market?  The answer is simple.  It is a random event, thus it is a different set of managers doing it each year!  Remember, markets are efficient and mispricings are random; therefore, how can a manager take advantage of random events?  Of course, everyone wants to believe there is someone out there who can predict market movements and consequently “figure the markets out,” and there will always be sharp managers that make that claim, but the reality is no such person exists.  

 

On the other hand Passive Management accepts asset class returns.  If the asset classes or the benchmarks are beating the active managers 85% of the time, why not buy the asset classes or benchmarks?  This strategy sacrifices trading costs and turnover in favor of tracking.  Instead of a concentrated and focused portfolio typically associated with active managers, passive asset classes and indexes have a much broader range of stocks in their portfolios resulting in less volatility.  The result is a better diversified, longer term, and cost saving strategy that is far superior in the long run.

 

Remember also, 94% of portfolio returns can be explained by asset class selection!  Market timing and stock selection make up the other 6%, however, those two techniques are actually shown to detract from returns

Passive Management of Portfolios is Superior to Active Management

Definitions:

  • Asset Class Selection
  • How assets are allocated in a portfolio.
  • Market Timing
  • Shifting portfolio assets in and out of the market or between asset classes.
  • Security Selection
  • Finding "underpriced" companies or industries.
  • The vast majority of a portfolio's returns veriance is determined by asset class

Source:  Study of 91 large pension plans over 10 year period.
Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, "Determinants of Portfolio Performance", Financial Analysts Journal, July-August 1986, pp. 39-44;
and Gary P. Brinson, Brian D. Singer and Gibert L. Beebower, "Revisiting Determinants of Portfolio Performance: An Update", 1990, Working Paper.