A Quantitative Analysis Of Active Management

by: Nicholas P. Cheer


Many believe they can beat the market by picking the right manager, and getting in and out at the right time.

Most investors do not realize that they are actually quite poor investors, and they are no better at picking the right managers at the right times.

Engaging in speculative active management investors are paying far more than they realize, and are likely harming their ability to create wealth over the long run.

Instead investors would be far better working with a knowledgeable advisor, and committing to an evidence-based approach that employs the science of investing.

"I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost...I'm on the side of the "efficient market" school of thought now generally accepted by the professors." - Benjamin Graham

A Quantitative Analysis of Active Investing

Over the weekend I completed Spencer Jakab's book "Heads I Win, Tails I win," and I recommend everyone go out and read this book. He shows in great detail why we are not the investors we think we are, and why active investing may be a lot of fun, but it is not likely to yield the results we expect. As a recovering active investor myself, it has reinforced all of the reasons why I believe in a structured evidence-based investment philosophy, and why high cost active managers, are significantly hazardous to your wealth.

Many investors today aim to achieve a return above the index. To do this they employ high-priced managers, who exude an aura of superiority, to speculate on where asset prices are likely to go, and place their bets accordingly. Most investors have very little knowledge about the effect those costs have on their long-term ability to create wealth. Likewise, they also fail to understand the mathematical improbability of finding a manager who can reliably produce alpha, year in and year out, that overcomes the cost of speculating in stocks.

In this piece, I want to go through what the challenges of speculating in stocks are, and why investors are far better served not with a passive index approach but rather by employing an evidence-based approach to portfolio management that harnesses the science of investing to engineer a portfolio that puts you on the road to success.

Compounding Costs are Eating your Wealth

Most investors see the cost of investment management as a necessary evil. Whether it is 1%, 2%, or 3%, the vast majority of investors would see this as insignificant when their exclusive investment managers can produce high levels of alpha in return. There are even some financial gurus who advocate investors use high fee funds, even those who charge high sales loads, with the justification that they have to look at what they are getting for the fee. A more preposterous statement, I cannot recall.

The reality is that investing is the one discipline where the old adage "you get what you pay for" does not apply. To put it simply, in investing, the less you pay, the more you get. The challenge is that most investors simply do not understand just how much that active manager is costing them. The expense ratio is just the beginning. Many funds also carry 12b-1 fees, loads, transaction costs, and if it's in a taxable account, one must also account for the tax cost. All of these fees add up, reducing any "advantage" an active manager can provide to 0% or in many cases, taking it negative.

Sales Loads

Sales loads are fees paid to "get into" a mutual fund. Load structures vary by share class. A shares have front-end loads (you pay when you buy it), B shares back-end loads (you pay when you sell it), C shares have level loads (spread out). Loads may be as high as 5% and generally have a breakpoint schedule based on the amount you invest. Losing 5% of your money right off the bat is quite a hurdle to overcome. Sales loads are completely unnecessary and investors should never invest in a fund that has a sales load, in my opinion.

12-b-1 Costs

12-b-1 costs are expenses that the fund company charges the investor in order to provide a kickback to the broker who sold it to you. 12-B-1 fees are used for marketing the fund, and investors pay this cost. Funds with 12-b-1 provisions should also be avoided in my view.

Expense Ratios

Expense ratios are what the average investor believes is the only cost they have to pay. These expenses cover the administration, distribution, research cost, and management of the fund. According to a study from Morningstar, the average expense ratio for all mutual funds was 0.64%.

Turnover-Transaction Cost

The level of turnover in a mutual fund tells investors how often the portfolio manager is trading the portfolio. A turnover ratio of 100% means that the manager is turning over the entire portfolio in a given year. The more they trade, the higher the cost covered by the investor. As there is no regulation that requires mutual funds to be transparent with their investors, transaction costs are generally buried in the Statement of Additional Information.

According to a study "Scale Effects in Mutual Fund Performance: The Role of Trading Costs," the average transaction costs an investor pays is 1.44%.

Cash Drag

Cash drag results from mutual fund managers holding cash to cover redemptions or as part of their strategy to lower risk. The investor, however, is paying the full expense ratio on 100% of their investment despite the fact that it may not be 100% invested in the stocks of the portfolio. There is also opportunity cost that must be calculated from cash drag as well. Studies show that the average cash drag cost is 0.83% per year.

Advisory Fees

Advisory fees are paid to financial advisors who assist individuals in managing their wealth. While an advisor can provide a valuable service giving an investor piece of mind, engaging in the proper planning, and saving investors from costly behavioral mistakes, it is an additional cost paid by investors, the average being around 1%. Added to a high fee investment strategy, and investors are setting themselves up for financial challenges.

Total Cost Summary

Let's assume you do not invest in funds that have sales loads or 12-b-1 provisions, and think you are ahead of the game. The reality is that the power of compounding costs are still eating away at your wealth.

Total Cost of Active Investing

Expense Ratio


Turnover Cost


Cash Drag


Advisory Fee


Real Cost of Active Investing


If an investor is holding funds in a taxable account, we would have to add tax cost to this, which would only increase the total expense. Funds may also charge redemption fees, soft dollar costs, opportunity costs, and other costs, many of which are difficult to quantify. Hopefully, you are beginning to see that active management costs much more than you thought, and the odds are simply not in your favor.

"Calling costs "death by a thousand cuts" is a little too dramatic, but the slow bleed can do a surprising amount of harm. A typical saver spends something like $ 170,000 in fees by the time they retire and gives up a fifth of their potential return. Can you imagine how people would react if, instead of paying that amount little by little and having to read about it in tiny letters buried in a quarterly statement most of us glance at briefly, we got presented with a bill for $ 170,000 at age sixty-five?" Spencer Jakab, Heads I Win, Tails I Win

Still many reason that their manager, will be able to provide a return over the index that will make up for all these costs and then some. Unfortunately, this does not happen in the real world of investing for two reasons. 1. Predicting which asset class will win in any given year is already an impossible task, but then to predict which manager will be able to beat the index is even more difficult, even impossible. 2. Research continues to prove, that those who win, even over long periods of time, have more to do with luck than skill and the alpha generated still does not cover the compounding effect of yearly costs.

Quantifying Investment Skill

The notion that an investor has the skill to pick a winning manager is just as improbable as that manager beating the index in any given year. In fact, we can use mathematics to prove this out. Within statistics there is a measurement known as the t-statistic. Here we can use the t-statistic to decipher how many years we would need as a sample size to determine if a specific manager has skill, or whether their results were simply the result of luck.

Mark Hebner, and the folks at Index Fund Advisors, have done a great job of doing many of these analyses on many of the most popular fund companies. His piece on Dodge & Cox was the final piece of evidence in a long trail that made me an evidence-based investor. Dodge & Cox is one of the most iconic fund companies in America. Morningstar refers to them as an ideal fund company, and if you twisted my arm and made me invest in active management, they would probably be the only firm I would consider. They have a long history of excellent returns, low cost, and consistently act as fiduciaries in the marketplace.

As you can see from IFA's analysis, the t-stat on Dodge & Cox's funds fail to crack the level necessary to demonstrate skill. For a fund to demonstrate skill over luck it needs to generate a t-stat greater than 2 to have a 95% confidence level that the returns are the result of skill rather than luck.

"Although the performance of Dodge & Cox's entire investment lineup has been impressive, they have not been consistent enough to determine that their investment acumen is truly a skill. While some might think that having a t-stat greater than 2 is a very unreasonable threshold to compare performance, we beg to differ. As a fiduciary, if we are truly making recommendations that are in our clients' best interest then we must be certain beyond a reasonable doubt that our recommendation is going to give them the greatest chance of capturing the returns the capital markets have to offer. Dodge & Cox can be added to the already mounting evidence that trying to beat the market is a fruitless endeavor."

Larry Swedroe, Director of Research at Buckingham Strategic Wealth, also performed an analysis of Dodge & Cox funds for AdvisorPerspectives. He concludes

"While the funds delivered outperformance over the full 15-year period, all of that outperformance occurred in the first one-third of that timeframe. For the last 5- and 10-year periods, the two funds have failed to outperform well-designed passive, lower cost alternatives."

The reality is that picking a fund manager who can consistently beat the market average is simply mathematically impossible. Rick Ferri's award-winning paper further makes the case by looking at a 16-year period, using index funds over an actively managed portfolio. The index portfolio won 80% of the time. What I found most interesting in this analysis, however, was that when the active portfolio won, it did so by only 0.7% per year, but when they lost, they did so by 1.6% per year.

I have made the argument many times in relation to US Treasury securities that you cannot beat compounding money, and it is clear that the tyranny of compounding costs is slowly working against active investors whether they know it or not.

A Better Way

While many would contend that investors should just sock their money into index funds and walk away, I believe mathematics and financial research demonstrates there is a better way. There is absolutely no doubt that John Bogle has been on the side of the individual investor for many years. His work in creating index funds, has given the average investor a fair chance at reaping the benefits of investing in capitalism and attaining financial freedom.

Through the years, many individuals have contributed to what we know about financial markets. Giants of the investment world such as Harry Markowitz, Myron Scholes, Eugene Fama, and Kenneth French have been at the forefront of advancing our knowledge of markets, and contributing to the science of investing. It is these scientific breakthroughs that have given rise to a new, more intelligent way to invest. This evidence-based approach is what the folks at Dimensional Fund Advisors, do every day.

Pushing the boundaries of investment science, and crafting innovative solutions that allow investors to harness more of the markets return, by tilting their strategies towards the dimensions of expected returns. In my upcoming pieces, I am going to explore many of the dimensions of stock and bond returns, and explore more fully why employing an evidence-based approach is not only superior to active management, but is also superior to market cap weighted indexing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.

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