Hi Guys,
Rick Ferri completely agrees with MikeM’s observation that increasing the number of actively managed funds in any fund category lowers the likelihood of positive Alpha (excess returns) in that category.
According to studies completed by Ferri, investors who hold multiple actively managed mutual funds in categories are swimming against the tide. Their odds of besting a single Index strategy decreases as the number of their active positions and the time length of those positions increases.
Two overarching experimental factors contribute to Ferri’s conclusions. First, the percentage of actively managed funds that outdistance their Index benchmarks is typically below 50% for any given year, and that percentage drops with increasing
years. Second, for those few funds that generate temporary Alpha, the positive outperformance is substantially less than the negative Alpha registered by those funds that fail to match the Index hurdle. It’s a double whammy.
Fund managers are smart folks, but selection and timing talents are overwhelmed by fees and costs.
Here is a Link to the whitepaper by Rick Ferri that makes “The Case for Index Fund Portfolios” based on extensive Monte Carlo simulations:
http://www.rickferri.com/WhitePaper.pdfFerri identified 3 Passive Portfolio Multipliers (PPM) in terms of returns enhancements: (1) Combining Index funds in a portfolio improves the odds of outperforming actively managed funds, (2) As time expands, the odds shift even more favorably towards Indexing, and (3) Increasing the number of actively managed funds in any asset class also increases the likelihood of Index outperformance.
This last finding directly addresses the issues discussed in this MFO exchange. The statistics are not attractive for those folks who hold multiple actively managed funds in various asset classes. Those studies are imperfect, but they are fairly constructed, honestly executed, and tell a compelling story.
The Monte Carlo simulations do not say it can not be done; in fact, they say it can be done. But the odds are long.
Ferri ran 6 different portfolio construction scenarios. In one of those scenarios, he limited the actively managed fund universe to funds whose costs were below the category average. Results improved, but the Index portfolios still outdistanced their active rivals.
An Index portfolio guarantees Index returns. Adding active elements, even one element, degrades the likelihood of delivering those Index rewards. If you feel you have an edge with one superior actively managed fund why not just invest with that agency? Mixing it with an Index product only dilutes the perceived advantage.
Portfolio diversity works, but there are limits. The law of diminishing returns comes into play. A long, long time ago, market wizards concluded that equity diversity in the US was asymptotically reached when the individual stock holdings approached the 40 level.
Holding 40 or more mutual funds surely does not add to diversity; it contributes complexity. I’m sure reasons exist for such complex portfolios, but diversity is not one of them. Holding so many funds is equivalent to holding the entire marketplace, except at an added cost penalty.
Ferri’s work reaches conclusions that are similar to a small number of earlier studies by researchers like Allan Roth. The odds are that the mixed portfolios, even if they include some Index holdings, will underperform a pure Index portfolio.
To misapply the words of Gertrude Stein: “There is no there, there”.
For the record, I currently hold a mix of both passively managed and actively managed funds. Over time, I am gravitating towards a higher fraction of Index positions. I do plan to keep some actively managed products. Sometimes, hope trumps logic.
Best Wishes.
