S&P takes aim at active management

Standard & Poor's, a division of the McGraw-Hill Companies*, recently published a piece entitled "SPIVA Scorecard: Active Management Myths." In it, the publisher of bond ratings, investment research, and the well-known S&P series of indexes (or indices) seeks to debunk what they call "enduring investment myths" surrounding beliefs that active management can outperform broader market indexes.

In addressing each "myth," the authors of the study present evidence that active managers did not outperform the S&P 500 index (for large-cap stocks), the S&P MidCap 400 index (for mid-cap stocks), or the S&P SmallCap 600 index (for small-cap stocks), based on data in Standard & Poor's database and from the University of Chicago's Center for Research in Securities Prices (CSRP).

We have been outspoken in our belief that active management -- that is, the effort to select companies for investment based on specific business criteria -- is superior to so-called "passive management" or investment based on ownership of companies contained in indexes. See for example "The active vs. passive debate" and "Would you prefer options linked to your company or to the S&P 500?"

We would argue that the Standard & Poor's study should not be taken as a proof of the weakness of the concept of true active management at all.

First, as we've said before, using the performance of mutual funds as a proof of the superiority of index investing over active investing is fallacious, because mutual funds by their very nature tend to impede the investor's ability to own exceptional companies for a long period of years, as we explain in "Some drawbacks of mutual funds."

Second, we would argue that the Standard & Poor's article misses the true concept of active management altogether. While we believe that the ability to invest in superior companies with superior management teams is the real advantage of active management, the Standard & Poor's article sees the advantage of active management somewhat differently. In discussing what they call the "Bear Market Myth," the authors state that "One of the most enduring investment myths is the belief that active management has a distinct advantage in bear markets due to the ability to shift rapidly into cash or defensive securities." In discussing what they call the "SmallCap Myth" they cite the belief that "the market for smaller stocks is inefficient and therefore conducive to active management."

In other words, they view the supposed advantages of active management as being based upon timing the markets (by jumping in and out of cash), timing sectors (by jumping in and out of "defensive securities"), or exploiting "inefficiencies." We have previously eschewed all three of those so-called "advantages" -- see for example "Ownership of businesses through multiple economic cycles" and also "Drawbacks of sector rotation." We also explained why proponents of index investing often take the zero-sum view that active management is simply about exploiting inefficiencies in "The zero-sum connection."

Finally, we would note that the classification of managers into "largecap" or "midcap" or "smallcap" -- or, for that matter, into "value" or "core" or "growth" -- is of dubious value to investors and results more from Wall Street's desire to create new products to sell than from investment considerations.

In fact, the very heart of what our blog has always been about is our conviction that investment is not the rocket science or mathematical mumbo-jumbo that Wall Street, much of financial academia, and most of the financial media make it out to be.

Into this category of unhelpful Wall Street distractions we would add the constant race to outperform this index or that index (and there are many hundreds of indexes to choose from). If you beat one index one year, it is always possible for someone to pull out a different index and demonstrate that you may have beaten that one, but you didn't beat this one!

Along with all of the other distractions, this pressure to beat every single index all the time only serves to take investors' eyes off of the ball, which is every bit as harmful in the investment world as it is in the baseball batters box. What investors should be focused on, as we have said many times before, is building their financial future on the firm foundation of the great companies that they own.

We were voicing these convictions long before 2008, and we would point out that the events of 2008 and 2009 have borne them out. The performance of the portfolios we manage outperformed the broader market indexes in 2008, and they have continued to do so in 2009 by an even more significant margin. Full performance data as well as GIPS disclosures through the end of the most recent quarter are available on our website's performance page.

While critics might respond that they are not saying that nobody can outperform indexes with active management, just that most do not, we would return to our first point that a study of the overall performance of equity mutual funds does not prove that point, either. Because of the size of most mutual funds, they often end up resembling the broader indexes themselves, as we explain here. In fact, with over $10 trillion in assets according to the latest ICI research, US equity mutual funds practically are the equity market. A study which uses that pool as their sample and then demonstrates that much of it did not "beat the market" is not telling us much of value about the efficacy of active management.

We are concerned that the Standard & Poor's SPIVA study might mislead investors into thinking that the evidence is clear that active management cannot outperform indexes, and that the most recent bear market has proven that yet again. In fact, we believe that the opposite is true, and that the results of 2008 and of the first three quarters of 2009 should show investors that ownership of innovative, well-run businesses is a valid approach and one that can weather even severe financial storms.

* The principals of Taylor Frigon Capital Management do not own securities issued by the McGraw-Hill Companies (MHP).

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