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Can Actively Managed Funds Out-Perform The Market, Consistently?

Summary

Are there any strategies that will consistently beat the market?

Are index funds the way to go?

Even stock market gurus under-perform the market throughout their career.

Since 1817, when the New York Stock Exchange first opened, investors have been trying to "beat the market". Beating the market can be defined in several different ways. When talking broadly about beating the market we often refer to beating the performance of the S&P 500. The S&P 500 is called a stock market index, or a set group of stocks that are reshuffled at the beginning of every year. Specifically the S&P 500 is made up of the United States' 500 largest companies by market capitalization.

Other popular indexes include the Russell 3000, Russell 2000, Russell 1000 and the Dow Jones Industrial Average, the 3000 largest companies, the smallest 2000 of the Russell 3000, the largest 1000 of the Russell 3000 and the 30 largest industrial companies in the United States, respectively. All of these indexes are used to measure the economic health, which is usually a good indicator of increasing profits, of different sections of the United States economy. The S&P 500 and Russell 1000 measure the health of the large companies in the US. The Russell 2000 measures the health of small companies in the United States, while the Dow Jones Industrial Average measures the health of the United States' industrial sector. The Russell 3000 is a measurement of the broad stock market in the United States. But, for the sake of this paper we are going to consider the market as the performance of the S&P 500, this is generally what people refer to in the finance world when referring to the market.

When people invest in the stock market they have two basic options: mutual funds and individual stocks. Individual stocks will always be the riskiest option when investing. If your one stock goes down you will lose your investment along with it, percent for percent. If you invest in a fund, it is a collection of many different stocks, so, if one stock goes down, you have the possibility of the rest of the stocks to bring your investment back up.

Of the mutual funds there are two main types, ones that invest to match the gains and losses of a single index. These funds closely follow the percentage gains and losses of that particular index throughout the life of the fund. The other type of fund is called an actively managed fund, these funds are managed by a fund manager whose goal is to try and beat a specific index. If the S&P 500 goes up 6% in a year, the actively-managed fund will look to beat that 6% by at least the extra cost it takes to invest in the actively managed fund. A manager considers to have beaten the market if he can beat the performance of the S&P 500 by more than the fees they are charging.

Mutual funds that follow a certain index are gaining more and more popularity lately. In part because of John Bogle, founder of Vanguard Investments. He revolutionized the investing world when his company began offering extremely low-cost mutual funds that tracked market performance. He could charge 0.19% of total assets and still make money because his company didn't need to hire a lot of research analysts and bankers to run the fund, it just needed rebalanced at the end of the year.

The low fees really hit the actively-managed fund community hard. Fund managers used to charge 2% of total assets and 20% of any profits made year to year. So, in order for these funds to beat the performance of their low-cost cousins they were required to beat the market by a significant percentage, a nearly impossible feat for most.

The real question today, which is at the forefront of investment banking topics is: Do actively managed funds provide a better risk to reward ratio in comparison to low-cost index funds? Our best answer can come from analyzing the arguments and data of some of the investors with the greatest returns over their life than any other investors, such as John Bogle, Peter Lynch, Benjamin Graham, Warren Buffet, and John Neff.

As I mentioned earlier John Bogle is the father of low-cost index funds. In his younger year Bogle was an avid supporter of actively-managed funds, simply because the low amount of data that he had in 1960 pointed to better returns from actively-managed funds. But, in 1975, after his previous firm came under fire after the go-go years of the late sixties, Bogle calculated the return of hundreds of actively-managed funds and compared them to the performance of the S&P 500, with the S&P outperforming actively-managed funds by around 1.5%, about the price of the fees involved in actively managed funds. Since that day Bogle has been a huge advocate of low-cost index funds (Ferri).

Peter Lynch, most notably famous for running the Fidelity Magellan Fund from 1977-1990 and averaging a yearly return of 29% during that time. His annualized return of 29% "beat the market" by 13.4% on average every year. Lynch is considered one of the greatest active managers. Peter Lynch's strategy to beating the market involved several different concepts. His first concept was, buy what you know. Many of Lynch's greatest stock picks he got at the grocery store or talking with friends and family. If you notice something new that is a big hit, it should interest you as an investment idea. His second, most important key is to do your homework. If a great product caught your attention, check and see how that contributes to total sales. If a great product only contributes 5% of sales, it will not make a big move in the company's bottom line. Also, check the companies' PEG ratio, the price to earnings to growth ratio. A PEG of less than 1.2 is ideal because it means that the growth of earnings is not already priced into current share value. His third and last key to beating the market is to invest for the long term. "A strong company with good growth potential will go up in value over ten years, but, trying to predict if a stock will be up or down in 2-3 years is nearly impossible", says Lynch, "and you might as well flip a coin".

Benjamin Graham, who was at the forefront of value investing, is amongst the most well-known investors in history. He was Warren Buffet's mentor and as you will see they both have very similar investing strategies. Both Benjamin Graham and Warren Buffet look for good companies that are currently under-valued. One of the first strategies they use to find their potential investments is to look at a companies with current assets greater than their long-term debt. The next step in finding stocks that Graham or Buffet would invest in is to find stocks whose earnings per share have grown at least 30% over the last decade and have never had negative earnings per share in the last five years. The price to earnings ratio should be no greater than 15, and when multiplied against the price to book ratio it should not exceed a value of 20.

Lastly, we have John Neff, a lesser known name then the aforementioned leaders in the finance industry. John Neff was most popular for investing in hot industries through a back-door approach. For example, if the housing industry was red hot, rather than buying construction companies Neff would buy into lumber companies that provided the construction businesses with necessary materials. Not only would he look for companies indirectly attached to hot sectors, but he was also a fan of low price to earnings ratios, and no negative earnings per share over the last five years. Along with being in stocks indirectly involved with hot sectors Neff also liked to buy companies after they released bad news and their stock had taken a hit. He says that as long as you were looking at a good company to begin with, one piece of bad news does not affect the long term potential of stock price, and he considered these dips in price to be bargains. Neff nearly always set up face to face meetings with a company's management before investing, he said it was to check their integrity and effectiveness. Although not feasible for individual investors, using Neff's technical and fundamental analysis you can still achieve a portfolio similar to his.

After a rough overview of some of the best United States investors, we can see that it is possible to beat the stock market, and maybe even possible to beat it consistently over the long-term. Even looking at what the industry considers the best investors we can see it is not easy to beat the market. Warren Buffet in his first 13 years had his stock earning 34% annualized, while the S&P only grew 30% over that whole time period. But, since 1974 shares in Berkshire Hathaway have only been earning 5.3%, underperforming the S&P 500. For determing what ideas or whose ideas will consitently outperform the market I would like to apply some of these principles to modern stocks and their prices over the last several years.

For this I will use Validea, a website that tracks portfolio's that have stocks determined by the approaches that famous investors used to take. According to this site, run by a MIT and Harvard graduate, each portfolio has out-performed the S&P 500 except for John Neff. Neff's simulated portfolio has had annualized returns of 5.5% since January of 2004, while the S&P has had returns of 5.6% during the same time period. Benjamin Graham's simulated portfolio has outperformed the S&P 500 by an annualized average of 6.8% since July, 2003. Warren Buffet's portfolio, which is similar to Benjamin Graham's, but not exactly the same is outperforming the market by an average of 3.5% every year since 2004. Validea also has Peter Lynch's portfolio outperforming the market by 4.3%, annualized.

According to recent performance in the modern stock market era, Benjamin Graham, who lived from 1894-1976, still remains the investing guru of all-time. But, with the other investors not far behind, and all but one beating the market, their strategies paint a very clear picture. The price to earnings ratio appears to be one of the most significant numbers in determining if a stock is a good buy at its current value. All of these investors include a low PE number as an important part of their stock picking strategy.

Now that we see that the market can be beaten in the long run, some may wonder why one would not always choose an actively-managed fund. Well, first off, I took the portfolios of the best investors to ever live, and they were only beating the market by 2-6%, with one of the greatest slightly underperforming in recent years. With an above average investor you could maybe expect returns that are 2%-5% greater than the market, but after fees that could be diminished to performing with the market, or beating the market by 3%.

When it comes to deciding between putting your money in an index fund, or an actively-managed fund you have to think about your goals, and the likelihood that you will be able to pick one of five managers that will outperform the market in any given year. Investors such as Graham, Lynch, or Buffet only come around so often, and the majority of the investing world cannot produce the returns that they do. Statistics show that 80% of people who invest in actively managed funds in any one year would have been better off investing in an index fund.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.