Why Active Mutual Fund Managers Fail

It’s not because of poor stock picking skills or high costs, the main arguments made by those favoring index investing. In this interview, a leading researcher on the topic says the conventional wisdom about active versus index investing is wrong. He explains why and the factors investors should look for when evaluating mutual funds.

There are two long and growing lines of research supporting the view that superior stock picking skill is the rule rather than the exception. The first finds truly active equity funds outperform. In these studies, the level of fund activity is measured by tracking error (the higher the better), benchmark R-square (lower the better), active share (the higher the better), and portfolio weighting best idea stocks (the larger the better), among other measures.

These results raise the question of why simply being more active allows the fund to outperform. If managers lack skill, as is so widely believed, then simply taking more high-conviction positions, for example, will not generate better performance. So, it must be the case that many managers are skilled stock pickers. This is what the second line of research finds.

Using a variety of approaches, a series of studies found that best idea stocks outperform other low conviction stocks in a portfolio, as well as outperform the fund’s benchmark. Thus, being truly active and having skill reinforce one another as the source of superior performance.