Larry Swedroe

Actively Managed Funds and the Implications of Increased Volatility of Equities

Recent years have seen a dramatic increase in the volatility of individual stocks. This has resulted in an increase in the cross-sectional volatility (dispersion) of returns in not only the U.S., but in international markets as well. It is important to note that this is not a sector (technology) issue. Nor is the increased volatility of stocks related to the stock market bubble. Instead, it is observable across sectors and markets (1).

The increased volatility has presented active managers with a great opportunity to demonstrate their skills of market timing and stock selection. It has also, as we would expect, resulted in an increase in the dispersion of returns of active managers, widening the gap between the best and the worst performers.

A study, "Cross-sectional Volatility and Return Dispersion," examined the returns of actively managed funds for the period from July 1988 thru December 2000 and found:

• The spread between the top five percent and bottom ninety-five percent of performers was almost always between ten and thirty percent in the quarters between 1988 and 1998. In 1999 it widened to over forty percent, and in 2000 it widened to sixty-six percent.
• For the quarter ending December 1998 the forty-four percent range was the widest in fifty-one rolling four quarters from the second quarter of 1986 to the fourth quarter of 1998.
• The dispersion was in evidence in the U.S. for both largecap and smallcap actively managed funds, and also occurred in Canadian, U.K., and Japanese markets.
• The spread in performance was not related to any change in skill levels or bigger bets, but was instead related to the increased cross-sectional volatility of equity markets (2).

The study's authors concluded that there were several implications for investors based on the results of their study on the increased volatility of stocks. The first is that despite the opportunity presented by the increased volatility, the bubble, and the bear market, there has been no evidence of active management outperformance. A Standard and Poor's study on active fund performance found that for the trailing five years ending September 2002:

• While the S&P 500 Index lost 1.6% per annum over the period, it outperformed 63% of all active funds. The asset-weighted average performance for active funds was a negative 2.9% per annum, underperforming their benchmark by 1.3% per annum.
• The Midcap S&P 400 Index returned 5.4% per annum, outperforming 93% of all active funds. The asset-weighted return for active funds was a negative 1.3% per annum, underperforming their benchmark by 6.7% per annum.
• The Smallcap S&P 600 Index returned 0.8% per annum, outperforming 67% of all active funds. The asset-weighted return for active funds was a negative 1.3% per annum, underperforming their benchmark by 2.1% per annum.

The second implication for investors is that the increased dispersion of returns increases the risks (the penalty for being wrong) of investing in an actively managed fund, as actively managed funds are not fully diversified across their asset class. As we saw from the evidence of the S&P study, the increased risks did not produce benchmark-beating returns. Active management has become a riskier game for investors, without a commensurate increase in expected returns.

Another implication is that if active managers try to compensate for the increased volatility and dispersion of returns by diversifying more across their asset class, they face the hurdle of the high costs of active management, but with index fund-like diversification. The effect is that the greater costs are magnified because they are charged against all assets, but are in reality spread across very little differentiation. This is a problem known as "closet indexing."

The final implication is that because there is a tendency for individual investors to believe (without any supporting evidence) that past performance of active managers is a result of skill, the greater dispersion of returns to active managers could lead investors to conclude that the few big winners resulted from skill instead of from random outcomes fully expected.

The greater volatility of stocks and the bear market presented active managers with a great opportunity to make their case. Yet the evidence is as strong as ever that active management is a loser's game. It is not that you cannot win the game of active investing. Instead it is that the odds of winning, combined now with increased risks/costs of losing, are so low that unless you place a tremendous price on the entertainment value of active investing, it does not pay to play.

References[/:Author:]
1. Ernest M. Ankrim and Zhuanxin Ding, "Cross-sectional Volatility and Return Dispersion," Financial Analysts Journal, September/October 2002.
2. Ibid.

Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," and "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," was published in June by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.