Excuses pile up for active management failures

(MoneyWatch) With apologies to Albert Einstein, there are three things that are infinite: the universe; human stupidity; the ability of active fund managers to invent excuses for their failure.

And I'm certain about only one of those. Whether it's Japanese earthquakes or rising correlations, there's always an explanation for the inevitable failure of active managers. A recent CNBC article provided a few examples of these excuses.

The article noted that only one in five active managers are beating their benchmarks this year, on pace with what we saw last year. Here are a few of the comments offered by active managers in response:

• "Clearly it's been a tough couple of years for active [managers]. For investors, you really have to have a forward-looking view."
• "Most professional advisors have a background in evaluating companies, industries, economies. It's not in politics, and politics is what [is] dominating the markets over the last couple of years."
• "Demonstrating the value of active management ultimately requires a thorough manager evaluation."
• "I don't think it's even possible anymore, the idea that you can buy and hold a diverse group of assets and hold them for 10 years."

The article went on to note that having a "forward-looking view" means investors "count on the importance of having advisors who can see through the fog of politically driven markets with tight correlations, where all asset classes essentially move together up and down."

Of course, that's sheer nonsense. Despite the fact that correlations have been relatively high, there has still been a very wide dispersion of returns, and that's all that matters for active managers. Wide dispersion of returns provides those "forward-looking" active managers the opportunity to select the winners and avoid the losers and outperform their benchmarks. Unfortunately, their crystal balls are cloudy.

• Is indexing ruining the stock market?
• Good news: Investors are fleeing active funds
• Active managers lag index counterparts -- again

It's the last quote above that really bothers me. First, buy-and-hold isn't a good strategy. Prudent investors buy, hold, rebalance and tax manage. But fortunately, investors seem to be flocking to the notion that passive investing gives them the best chance of achieving their financial goals. It might have something to do with the fact that active funds tend to lag their index counterparts.

The reasons are numerous, but simple logic dictates that, as a group, active managers can't win consistently. As Nobel laureate William Sharpe explained in his paper, "The Arithmetic of Active Management": "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

Sharpe also provided this insight: "The market's performance is itself an average of the performance of all investors. If, on average, mutual funds had beaten the market, then some other group of investors would have 'lost' to the market. With the substantial amount of professional management in today's stock market, it is difficult to think of a likely group of victims."

Image courtesy of Flickr user purpleslog