Active Investing by Money Managers Loses in Risk Study

Sam Mamudi of the Wall Street Journal deservingly poked money managers in the eye with his recent report on how such mangers underperformed indexes in both real and risk adjusted returns as revealed by a rigorous Morningstar study on the subject.

As Mamundi states, “While it has been established that most actively managed mutual funds lag behind their indexes over time, [this] study further twists the knife: Active management suffers even more by comparison on a risk-adjusted basis. The study found that in many cases where an actively managed fund beats its index on an absolute basis, the additional risk it took didn’t justify the returns earned. Not only should that be a warning sign for investors — because greater risk means greater volatility — but it also suggests that fund managers aren’t living up to what is expected of them.”

As Mamundi points out, it is typically thought that a riskier fund should reward investors with higher returns, but contrary to this popular thinking, over the past three years higher risk has equaled lower returns. Travis Pascavis, director of equity indexes at Morningstar, further explains that, “The key to thinking of risk in terms of returns versus an index is that, in theory, if investors wanted to take on more risk for greater returns, they could simply buy an index fund and lever up their exposure. That would also increase returns while adding risk — and do so at a cheaper cost than most actively managed funds. It is against this standard that actively managed funds should be judged.”

Although we at MarketRiders do not encourage adding risk to a globally diversified portfolio of ETFs via leverage or any other means, it is interesting to note that highly paid money managers once again seem to be the only ones benefiting from their higher-risk game.