craschworks

[Note, in what follows, I'm speaking for myself, not my company.]

I don't talk about it much, but my company, Marketocracy, is very cool. I'm writing now, because a) we have something to crow about and b) I'm going to shamelessly ask y'all to help me stuff some ballots.

“Five years after making the biggest bet of his life, John C. Bogle, founder of the Vanguard Group, collected $25 from Robert Markman of Markman Capital Management.

In 1995, after Markman had been had been criticizing the foolishness of passive index investing for years, Bogle, a longtime proponent of passive index investing, challenged him to the bet.

The Moderate Allocation Fund that Markman chose was outgained by the Vanguard 500 index fund 226 percent to 156 percent over the five-year period. With taxes figured in, the margin was even greater, 214.3 percent to 113.5 percent.

While gracious in sending the check to Bogle, “I trust you will invest it wisely,” he complained that he had chosen the wrong fund. The Markman Aggressive Allocation Fund returned 240 percent (pretax) over the same 5-year period.

“He says he bet on the wrong one,” Bogle said, “That's like saying I bet on the wrong horse.”

(Bogle Wins $25 Bet Index Funds Staff.)

Unfortunately, a lot of people are betting on the wrong horse.

Research sponsored by Lipper shows that, for the 10-year period ending June 30, 2000, only 26 percent of actively managed U.S. stock funds outperformed the S&P 500.

According to the Investment Company Institute, as of 2001, the combined assets of diversified equity mutual funds totalled more than $3.42 trillion. 84% of that money is invested in actively managed stock-picking funds.

Why do active investment managers perform so poorly?

First of all, looking the market as a whole, it's mathematically impossible for more than 50% of actively managed funds to beat a broad based market index–even if you ignore fees.

Why?
According to William Sharpe,

“….Assume that you in this room constitute the entire universe of investors in the French stock market. About a fourth of you will be passive indexed investors, while the rest will be active investors. Collectively you hold all the stock on the French market. Now let's pick a time period — say a year. And let's say the market as a whole returned 10.0% in that year. Before costs, what did each passive investor get? Exactly 10.0%. Obviously, before costs that average passively managed Euro returned exactly 10.0%.
What about the active investors? One might have made 15.1%, another 3.4%, yet another -23.0%, and so on. But what did the average actively managed Euro invested in the French stock market return before costs? The answer has to be exactly 10.0%. Why? Because the passive part returned 10.0% and the total market returned 10.0%. So the active part had to return the same.
We conclude then that in the French stock market the average actively managed Euro must have the same return before costs as the average passively managed Euro….”
(Indexed Investing: A Prosaic Way to Beat the Average InvestorWilliam F. Sharpe. Presented at the Spring President's Forum, Monterey Institute of International Studies, May 1, 2002)

In actual practice, as illustrated above, actively managed funds don't even come close to the theoretical limit. In part, this is because actively managed funds must pay several costs not borne by passive funds, including:

• Research Cost: Analyzing and identifying stocks to invest in requires a substantial amount of time and effort. These research activities can be self-performed, but it would be hard to compete, from an opportunity-cost perspective with a specialist's expertise and economies of scale. Most mutual fund managers charge between one and two percent of assets under management as research fees.
• Tax-Inefficiency Cost:Active trading is tax-inefficient as capital gains are due each year as stocks are bought and sold under active management. Placing a number on this cost is difficult as individual tax status and tax rates differ, but a quick and dirty estimate is at least one percent a year.
• Transaction Costs: Brokerage commissions and bid-ask spreads detract a lot more from the performance of active funds due to their much higher frequency of trades. A rough estimate puts it at a little over one percent a year.
• Undiversified Risk Cost: Sub-optimal diversification of an active fund adds risk to a portfolio that could have been avoided by investing in an index fund. This risk cost is estimated to be about one percent per year, similar to the transaction and tax costs.

These four costs of active management result in about a four percentage point handicap per year, compared to passive investing. (The Inefficient Markets Argument for Passive Investing”
by Dr. Steven Thorley Dr. Steven Thorley Indexfunds.com. 1999.)

average expense ratio for actively managed funds is around 1.46% vs. 0.46% for passively managed funds.

e've developed the first farm system for mutual fund managers.

Here's how it works.

We operate stock market simulation on our web site, Marketocracy.com.

Here's the results of our fund since inception, compared to the S&P 500.

IMPORTANT CAVEAT! We've only been in operation since November, 2001.