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One thing I notice when lovers of indexing write about the underperformance of active managers, is that they only focus on the idea of how the managers don't "beat their index".

When I buy an ETF or a mutual fund for a client, I rarely choose it based on my hopes that it will somehow beat an index. I am more concerned with how the manager goes about getting their returns.

Here is an example that I have used before but it is germane to this topic. It usually takes about 6 hours for me to drive south to Los Angeles from my home. Assume you approach me as your "driving manager". I give you a few options. Based on following the speed limit (indexing), I tell you that I can get you there in the 6 hours, as we will take normal risk that goes along with driving the speed limit. We will still risk getting in an accident from other drivers not paying attention, or from me being tired from driving so long. We have risk from other drivers behind us who want to go faster and are getting angry. Doing this, at least you won't risk having to help pay for any speeding tickets! It is boring, but gets us to where we need to go. You will get the full risk and expected performance of one who fully abides the law.

Next I give you the option of getting there in 4 hours. To do this, we will need to average 90-100 MPH the whole way. You really like the sound of the outperformance, but the risks to get there are extremely high, and should not be ignored. Our chances of dying if we get in a crash goes up something like 30% for every 10 MPH over the speed limit that we travel. Is outperformance still your goal if you have a much higher chance of dying?

Is outperformance in the stock market really your goal if you have the chance of losing more if things go wrong? Why do I say this? Articles like the one above are skewed at best. From what I read, unless the funds get you to your goals quicker, these money managers are considered failures by these authors. What the article forgets to analyze is how many active managers take less risk than the index they are supposed to beat.

I would much prefer to own a fund of an active manager who underperforms the S&P 500 by 10 percentage points over 5 years if that manager took half the risk of the index. I would also run from a manager who beats the index by 10% over a 5 year period if that manager took 50% more risk than the index. Outperformance alone is not something an investor should look at. They should primarily look at risk adjusted returns.

You can do this by looking at the Beta of a mutual fund or ETF. Don't stop at performance numbers. Know the risk the manager takes in the space that they invest to determine if they did their job well or not. As stated above, I will always choose the investment that underperforms but with much less risk. It is always a matter of math. Losses are so hard to make up mathematically. If the S&P 500 goes up 7% a year for 5 years, an investor who had $100,000 at the start sees the investment grow to $140,000+ after compounding. Another large cap fund that is compared to the S&P 500 offers half the risk, and only returns 5% per year during that same time. After 5 years this investor instead has only $127,600. Everyone seems to want to harp on this manager and tell you that you should index because most managers can't beat the indexes.

Now for reality. If the market crashes by 40%, the indexer sees their account go from $140,000 down to $84,000. Ouch! But at least you can feel good that you matched the index?

The underperforming manager who took half the risk saw their fund drop by 20%. The $127,600 turns into $102,080. Still a profit! The underperforming manager had much better risk adjusted returns.

So the next time you hear a sales person try to pitch you on the idea of indexing being better because most managers can't beat their respective index, know that the person saying it has a bias and sales bent. You should now know that there are plenty of active managers who run ETFs and mutual funds who are not beating the indexes, but are providing much better risk adjusted returns.

Disclosure: I am short SSO.