We all know actively managed funds as a group fail to beat indexes.

A new study released by Morningstar finds that active managers fall even further behind on a risk-adjusted basis.

Simply put, this is a measure of how much risk is taken on to receive a rate of return.

The study found in many cases where an actively managed fund beat its benchmark index it did so by taking on greater risk.

“It’s not enough to beat an index in a way that [assumes more risk],” said Travis Pascavis, director of equity indexes at Morningstar. A riskier fund should provide greater returns, he added.

There is no free lunch.

Ken French, professor of Finance at Dartmouth, explains why active investing is always a negative sum game.  Ken explains why in good markets and bad active investors always underperform by their fees and expenses. Click on photo to view video.

The S&P 500 has gained 13.52% YTD and up about 50% from its low in March.  That is pretty impressive.

However, a portfolio composed of broadly diversified asset classes is up over 27%, or about double the S&P 500.

Diversification works.

Widely cited as the father of the efficient market hypothesis and one of its strongest advocates, Professor Eugene Fama examines his groundbreaking idea in the context of the 2008 and 2009 markets. He outlines the benefits and limitations of efficient markets for everyday investors and is interviewed by the Chairman of Dimensional Fund Advisors in Europe, David Salisbury.

Are you above average?

If you are like most people you likely believe you are.

Better than 90% of surveyed factory workers said they were above average.

A study of college professors found that 94% of them thought they were better than their colleagues.

This sense of overconfidence, which is sometimes called the Lake Wobegon Effect, includes lots of areas, according to economist Robert Frank, who was recently interviewed about this on NPR.

More than 90% of drivers think they are above average and even 85% of drivers in the hospital due to an accident they caused think, yes, they, too, are above average in their driving ability.

This comes from Bill Schultheis, author of The New Coffeehouse Investor and a blogger we really enjoy.

If you invest in actively managed funds, you have the hope of outperforming the market. In return, however,  you must accept the risk that your manager will underperform. The table below contains nine percentages, each representing the rate of return a money manager is guaranteed to earn going forward.

This is like the world of investing.  If you chose an actively managed fund and the market returns 10 percent, you might be fortunate and earn as much as 23% per year. However, you are just as likely to be unlucky and lose 3%,  A rational, risk-averse investor would logically decide to  accept the 10% market return.

The only reason investors choose to play the game with actively managed funds is they are overconfident of their abilities to identify the few active managers that will succeed in beating the market.

Unfortunately, overconfidence is a very common human trait that hardly ever pays off. More on overconfidence  in another post.

In today’s dollars it cost $150 billion to put a man on the moon.  As we celebrate the fortieth anniversary of that momentous event our government is spending $700 billion to bailout troubled banks.

We have regularly reported (in fact as recently as our last post) how active managers struggle and fail to consistently beat benchmarks.

Well, Barron’s reported in a recent issue about a study done by a finance professor at the University of Texas at Austin whose research says hedge funds as a group don’t do any better than active mutual funds.

Prof. John Griffin said that he was a little surprised by his findings since hedge fund managers charge their clients a whooping 1% to 2% a year and 20% of the profits to be apart of their offering.

Using a sample of 300 hedge funds and much of the mutual fund universe, Prof. Griffin compared the performance of the funds’ equity holding based on their filings with the Securities and Exchange Commission.

Like active fund mangers, the study found no ability to time the market.

The column’s lesson for prospective hedge fund investors:  Don’t make an alpha bet.

Sounds like good advice for everyone.

Active investing is a zero sum game—before costs. After costs, active investing is a negative sum game. Why? Check out the recent post by Professors Gene Fama and Ken French by clicking here.

Today Bernie Madoff, who swindled billions, received the maximum sentence of 150 years in jail.

Unfortunately, he leaves behind many devastated lives.

Everyone hurt, by what might well be the largest Ponzi scheme in history, were not among the super rich.

Many were ordinary people who entrusted advisors to select the money manager best suited to invest their hard earned savings, much of it retirement.

Associated Press carried an article about Jack Cutter, an 80-year-old in Longmont, Colorado, who had to go back to work and is now a butcher at Safeway supermarket, after losing his retirement nest egg to Madoff’’s crimes.

Cutter spent a lifetime as a petroleum engineer, a profession he is no longer equipped to do.  “My slide rule skills are pretty much outmoded,” he said.

It is doubtful that Madoff who is nine years younger, will be assigned a prison job as demanding as Cutter.

The lesson for investors is to know what you own.  Understand the investment process, what are the underlying securities, and where and how they are held.

Tragically all the Jack Cutters of the Madoff world are sentenced to a future they did not plan or want because they trusted an illusion.

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