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.

The financial media is pleased to report that the best performing mutual fund of the decade is Ken Heebner’s CGM Focus fund.

Through the end of January, 2010, the mutual fund annualized 18.03%, easily outpacing the S&P 500’s annualized return of -0.55%.

Did you miss these returns? Not to worry, because the typical investor in the CGM Focus mutual fund also missed out on the returns. Unfortunately, there is a big difference between investment returns and investor returns.

The financial media always focuses on investment returns. In other words, what did a specific investment return? In this case, the media focuses on the great track record the CGM Focus mutual fund had over the last decade.

Of course, the media rarely focuses on investor returns. In other words, how did the typical investor perform in the same investment? Luckily, Morningstar calculates dollar-weighted returns, which represents the returns real investors receive based on buying and selling.

Here are the 10-year annualized results through the end of January, 2010:

• CGM Focus: 18.03%
• Typical CGM Focus Investor’s return: -13.73%

How can this be? How did investors lose money in the best performing stock fund of the decade?

Simple. Poor investor behavior.

Most investors make buy and sell decisions based on past performance. As the financial media was happy to point out, CGM Focus returned 80% in 2007.

Believing this trend would continue, investors poured a whopping $2.6 billion into the fund in 2008.

Then, in horror, investors watched as the fund tanked -48.2%. Disappointed with the results, investors yanked more than $750 million out of the fund.

The typical CGM Focus investor missed all the gains in 2007 and captured all the losses of 2008.

Don’t fall victim to poor investor behavior and media hype. Understand there is a difference between investment returns and investor returns.

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With the dawn of a new decade arrives the financial media’s recommended investments.

Articles with attention grabbing titles such as “10 Stock Investments for the Next Ten Years” entice readers with promises of market beating returns.

But should you follow media’s investment recommendations? Consider the following articles published ten years ago.

In August, 2000, a Fortune magazine article presented “10 Stocks to Last The Decade.”

How would these ten stocks have performed if you spread your investments equally among each pick versus the market and a fully diversified portfolio*?

• Fortune’s 10 Stock Investments:  -44.21%
• S&P 500:  -7.26%
• Diversified Portfolio: +81.04%

Time period – August, 2000 through November, 2009.

Fortune’s stock picks drastically underperformed both the market and a fully diversified portfolio.

A second article by The New York Times asked for Buy and Hold picks from “10 very smart, very successful investment professionals…”

So how did these stock picks fair versus the market and a fully diversified portfolio?

• New York Times:  +25.17%
• S&P 500: -4.29%
• Diversified Portfolio:  +84.35%

Time period – February, 2000 through November, 2009

The New York Time’s picks beat the market but it seems a passively managed diversified portfolio drastically outperformed these “very smart, very successful investment professionals…”

Think twice before rushing out and investing your money in any of the media’s picks for the next ten years!

Having a financial plan and a fully diversified portfolio based on this plan is the best bet when investing for your goals and future.

*Fully Diversified Portfolio:
Dimensional US Adjusted Market 2 Index: 30%
DFA Equally Weighted Emerging Markets Index: 5%
Five-Year US Treasury Notes: 40%
Dimensional International Market Index: 25%
Rebalanced annually

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From the January, 2000 Smart Money Magazine:

“The Underachiever’s Club – Thanks for Nothing: Sixteen mutual funds reopened to new investors in 1999. But returns for these three make you wonder why they bothered.”

The three mutual funds highlighted in Smart Money’s “Underachiever’s Club” were:

• Lord Abbett Small-Cap Value
• Neuberger Berman Genesis
• Vanguard Windsor

The Smart Money article focused on each fund’s market underperformance since reopening – a period of only six months! Six months is hardly enough time to judge an investment or investment strategy.

Of course, it’s easy to find winners and losers using hindsight. The problem was, this article highlighted these funds as losers although they were on the verge of outperformance.

Look at the subsequent five-year (2000-2005) compound returns for each of Smart Money’s “underachievers” versus the general market.

• Lord Abbett Small-Cap Value: 17.05%
• Neuberger Berman Genesis: 17.44%
• Vanguard Windsor: 7.62%
• S&P 500: -1.13%

Investing based on tips from the financial media is dangerous to your wealth and will not help achieve your goals.

Finding an advisor you trust and developing a plan with that advisor will!

*This article does not represent a recommendation to buy or sell the mentioned funds. Past performance does not guarantee future results!

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