Proponents of active investment management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction.

While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active investment managers do not consistently deliver on this promise, according to research provided by Standard & Poor’s .

S&P Indices publishes a semi-annual scorecard that compares the performance of actively managed mutual funds to S&P benchmarks.

The report analyzes the returns of US-based stock and fixed income managers investing in the US, international, and emerging markets.

Over the last five years:

• About 60% of actively managed large cap US stock funds did not beat the S&P 500
• 77% of mid cap funds did not beat the S&P 400
• two-thirds of the small cap manager universe did not outperform the S&P Small Cap 600 Index
• Underperformance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.

Furthermore, across the thirteen fixed income fund categories, all but one manager experienced at least a 70% rate of underperformance over five years.

Proponents of active investment management will simply say buy managers who can outperform the market. Of course, a couple problems occur with this strategy:

• It is impossible to identify managers who will outperform the markets in the future.
• Most managers who have outperformed the markets cannot consistently do so in the future.

The message is clear: As a group, actively managed funds often struggle to add value relative to an appropriate benchmark—and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.

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One outcome of the financial crisis is we have to “live with messiness.”

Instead of a neat and tidy explanation for everything that happens in the markets, humans are sometimes irrational and, as emotional creatures, we occasionally let fear and greed cloud our financial decisions.

After witnessing the current financial crisis, the tech stock bubble and burst from a decade ago, and numerous other financial storms over the past 20 years, it seems that when it comes to money, humans continue to make mistakes with their money and investments.

In a very interesting September 2 New York Times Magazine article, Nobel Prize winner and liberal economist Paul Krugman discussed the development of economic thought over the past 230 years and how the current financial crisis has thrown economic theory into disarray.

Without getting into his political leanings, Krugman makes a case that almost all economists, whether they be conservative or liberal, financial or macroeconomic, missed this crisis.

Despite their impressive-looking mathematical formulas and hundreds of years of history, economists, in general, failed to predict the size and timing of our current worldwide maelstrom, and, worse yet, were generally blind to the idea that a catastrophe of this size could even happen in this (enlightened) day and age.

Krugman says economists, “Will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.”

In short, he says we have to “live with messiness.”

From a practical standpoint, it reiterates the importance of knowing that the financial markets are not perfectly rational and that they do not always behave in the way that econometric models predict. One could argue that changes in the financial markets are simply a reflection of the sentiments, fears, dreams, and hopes of us – the market participants. The markets are not separate from us – they are us!

Since we humans are, well, human, then the markets may behave in a way that reflects human behavior and that can get quite messy.

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A recent Wall Street Journal article epitomizes the new “conventional wisdom” that asset allocation failed in 2008.

It is true that correlations among major asset classes have increased in recent years giving the impression that asset allocation no longer works.

During the 2008 financial crisis all major equity asset classes experienced severe declines. Even commodities, which historically had exhibited low correlations to equities, dropped dramatically.

This does not mean that diversification and asset allocation failed.

• High-quality fixed income securities, i.e. U.S. Government bonds, of all maturities were a safe haven and had returns ranging from 1.6% to 25.8% percent in 2008.*
• Financial and economic shocks are rare occurrences, and investors must understand that they are part of the risk of investing in equity markets. Correlations historically have increased during economic shocks but returned to more normal levels as economic conditions normalized.
• Asset allocation depends on individual circumstances. If one has a high overall risk tolerance and a very long investment time horizon, accumulating shares during bear markets may be a wise strategy.

The major problem is, so many articles in the financial press are devoted to attempting to avoid investment losses. These articles make it seem that market timing can work for most investors. Many nervous investors needlessly adjust portfolio holdings, usually to their long-term detriment, in an attempt to grab the current “trend.”

In reality, alternatives like market timing, short selling, and stock picking have historically tended not to work as claimed for most money managers.

Your best bet for financial success is to stick to your plan and your appropriate asset allocation.

*Source: DFA Returns 2.0; One-month T-Bills and Long Term Government Bonds, respectively.

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This question has been coming up a lot lately in the media and some academic journals. Thinking Modern Portfolio Theory died last year is based on the misconception that Modern Portfolio Theory will guarantee against a loss.

That is simply not the case. What MPT believes is diversification to a portfolio, which over the long term can potentially reduce a portfolio’s volatility versus a single asset portfolio.

According to a recent article in Investment News:

• MPT does not guarantee against a loss
• Fixed income helped reduce the amount of loss in many portfolios last year
• Many advisors are finding that their clients had too much equities and not enough fixed income for their risk tolerance

Remember, when investing in a diversified portfolio, you will experience negative returns periodically.

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How will we know when the market hits rock bottom and starts a new secular bull market?

This is one of those questions where if we knew the exact answer we could probably make a fortune. Unfortunately, no one cannot pinpoint the bottom of a bear market in real time, but according to money manager John Hussman, there’s an anecdotal measure that might help us narrow the timeframe.

In his June 29 commentary, Hussman discussed the concept of “assumed permanence of unusual conditions” to help describe both major market peaks and major market lows.

He referenced the 2000 technology peak, the recent housing peak, the 2007 stock market peak and the 2008 oil peak as examples of investors believing in the “assumed permanence of unusual conditions” to justify such high prices.

We now know that those “unusual conditions” were anything but permanent.

Conversely, he said the same sentiment applied back in early 1982 to help justify why the stock market was dead and would continue to be dead for years. Of course, in August 1982, the stock market took off on an 18-year bull run.

What we’re really talking about here is that at certain times, investors might become so euphoric or so despondent that they believe the current trend will last for many years.

Today, investors are understandably concerned about the financial markets.

We’ve been in a down cycle since October 2007 and there’s plenty of anxiety about how much longer it will last. But, have we reached the point where many investors take it as a given that these unusual economic and market conditions will be permanent?

Hussman suggests that when or if we reach this point of “assumed permanence of unusual conditions,” then that might be the time when we create a floor from which a new long-term bull can begin.

It’s a great theory, but no one has an empirical way of measuring when we hit this point.

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