Today, there are two widely accepted approaches to investment management: active and passive. Active investment management simply means that a manager is actively looking for good investments and selling those he thinks will do poorly. Passive management accepts the premise that it’s nearly impossible to beat the market and simply invests in the market. In a passive approach, the manager simply seeks to keep the investments equal to an index, most commonly the S&P 500.
Passive management has the advantage of not ever doing significantly worse than the market, because it’s “shadowing” the market. Of course, that also means it wont beat the market.
Active management has the potential to beat the market, but in order to beat the market an active manager must invest differently than the market. This means that the market will beat the active manager in some periods. Just how often good active managers underperform is surprising. A study of the top 25% of mutual fund managers in the first decade of this century showed that 79% spent at least 3 years in the bottom 25% (Greenblatt 2011).. In other words, if you would have stayed in one of the best mutual funds, there was a 79% chance that you would have endured 3 years of poor performance. Most investors can’t endure this, and it’s costly for them. The best performing mutual fund in the same decade returned an average of 18% annually. To do this it had to invest very differently than the market. This means it had periods of beating the market significantly, and also periods of significantly falling behind the market. Could you stay invested during these poor periods? Probably not. The average investor in this fund lost 11% annually as they bought into the fund after a strong period and sold after it did poorly, exactly the opposite of what they should have done.
Closer to home, the Haas Capital Management U.S. Equity Strategy beat its benchmark (the S&P 500) in the three year period 7/1/12 – 6/30/15 by a respectable 2.8% annually. But in the one year period ending 9/30/14 the strategy returned only 7% while the benchmark returned 20%, a very poor showing. It’s tempting to interpret this as a sign that the strategy no longer works, but that would be a mistake. It’s simply a sign that the strategy invests differently than the market in an attempt to beat it. It seems obvious, but it’s worth stating: investing differently will produce different results.
If you choose the active management approach know that there will be periods of heartache, even when you’re investing in a “good” strategy. Know your reasons for investing before you put money in, have reasonable expectations, and have clear criteria for when to change managers or funds.