Four reasons for active fund managers woeful run

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If your investments are being steered by active fund managers, here's a little tip: When you open that statement, you might want to shield your eyes.

That's because fund managers who pick and choose their stocks, rather than passively follow an index, are having a year to forget. Only 27 per cent of large-cap managers are beating their benchmarks year-to-date, according to new research from Bank of America Merril Lynch.

Growth managers, in particular, aren't earning their paycheques, with only 12 per cent outperforming their indices.

Indeed, if anything, active managers seem to be getting worse. Last year, Standard & Poor's Spiva scorecard — which measures active funds against their benchmarks — revealed that 34.3 per cent of large-cap managers beat the S&P 500 for 2010.

Which begs the question: What's going on? It's a very tough environment for active managers right now. There seems to be limited opportunity to find winners." Active-versus-passive investing used to be a lively debate for market wonks. On one side of the argument, index proponents like Vanguard Group founder Jack Bogle say pairing low fees with market-mirroring returns is the most reliable way to build your portfolio. On the other side, there are star managers like Legg Mason's Bill Miller, who famously beat the S&P 500 with his picks for 15 years in a row.

Recently, though, the contest has turned into a bit of a rout -and even Miller is exiting his flagship fund (but remaining chairman), after trailing the index for four of the past five years.

Some reasons for the mismatch are evergreen, like the higher fees that actively managed funds must overcome. Active large-cap funds at present have an average expense ratio of 1.28 per cent, versus 0.68 per cent for similar index funds, according to the Chicago based fund research firm Morningstar.

But the past couple of years have been particularly rough sledding for active managers, and it seems everyone has a different theory as to why. Some of the most oft-cited culprits: High correlation: Historically, when a particular sector is tanking, money managers are able to sidestep the carnage by migrating elsewhere. But when there are no safe havens anymore, where do you go? Because of the extreme volatility in the market right now, correlation is as high as it's ever been. When fears of a European sovereign default sell the market off, it sells off powerfully — and takes every sector and stock with it. Style cheating: As the US economy languished after the financial meltdown, some managers of domestic equity funds began nibbling at international stocks for a little performance boost. But as Europe began to blow up, they started to wish they hadn't.

This year that worked against them, as global stocks underperformed.

Betting wrong on dividend: High-yielding stocks did pretty well in November, generally leading the market, according to Savita Subramanian, head of US equities for Bank of America Merrill Lynch. Too bad active managers weren't on board. "Sectors with the highest dividend yield are most underweight by active managers," she wrote in a recent performance report.

Cash drag: At any given time, most equity fund managers hold some cash to keep their powder dry for future purchases. But with interest rates so low, that cash is basically earning nothing and can be a lead weight during market rallies, says Geoff Friesen, an associate finance professor at the University of Nebraska-Lincoln.  If the S&P earns 6.8 per cent but a fund has 10 per cent of its assets in cash and the other 90 per cent in the S&P, the fund will earn 6.12 per cent, substantially lagging the benchmark. So, even if the stock component of a fund exactly matches the S&P 500, the cash component drags down returns during positive-return periods. While active managers are fielding the weaker team right now, keep in mind that not all sectors act alike, notes S&P's Dash. An active and seasoned captain can be an advantage in trickier waters like international smallcap equities and emerging market bonds, where managers tend to beat their benchmarks.

Nor are all fund families alike. While past returns are no guarantee for the future, some firms boast a menu of active funds that have performed impressively in recent years — like Baltimore-based T Rowe Price, which was ranked among the best fund families in the country by Barron's and fund-research firm Lipper, a Thomson Reuters company. In a world where everyone's focused on the next data point, we're focused on what companies are going to look like three years from now. That long term approach is fundamental to our success, because there's less noise and more visibility. On the average, though, realise that expecting your active fund manager to beat the market over the long term — especially during an era of economic Black Swans — is a risky bet. If you want to go active in your quest to beat the market, there's nothing necessarily wrong with that.

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