Filed under: Investing Basics, Scandals and Lawsuits, Investing
Given these beliefs, you can imagine my surprise when I uncovered a form of active management that actually makes sense. Understanding why this exception works may help you reassess the way you currently invest.
Active Management That Works
According to a February article in the Financial Times, a French citizen could become a billionaire by the end of this decade, all thanks to the unique wording of a life insurance agreement given to him by his father. Starting in 1987, a French insurance company called L'Abeille Vie (now part of Commercial Union) began offering a "special deal" to its wealthier clients. It was called a Fixed Price Arbitrage Life Insurance Contract.
Pursuant to the terms of these policies, holders allocated their dollars to different investment funds offered by the insurer. Prices for the funds were published each Friday. However -- and this is the unique part -- clients were allowed to switch funds at those prices any time before the next price was published, even if the markets moved up or down in the interim.
The ramifications of this provision were profound. If a fund increased in value, it could be purchased at the lower price published the previous Friday. If the price went down, the fund could be sold at the higher price published the previous Friday. These provisions gave the holder of the policy a risk-free way to earn staggering returns.
Not surprisingly, for the decade commencing in 1997, the investments of this lucky policy holder increased by 68.6 percent annualized.
The insurance company is fighting to have these provisions overturned. So far, it has had no success.
Clearly, this is a form of active management that works. Unfortunately, it is no longer available.
Active Management That Doesn't Work
The bread and butter of almost all dealer-brokers and many advisors is their ability to convince you they can "beat the market." What they are really saying is that they can predict tomorrow's prices and give you the chance to buy at those prices today. However, unlike the special situation involving the French insurance policies, they are just guessing at tomorrow's prices. They may be right or wrong, but if they are correct, it's more likely attributable to luck rather than skill.
And active management's long-term track record does not inspire confidence. Exhaustive, long-term studies published in peer-reviewed journals have found relatively few actively managed funds produce benchmark-adjusted expected returns sufficient to cover their costs. Over the past five years, more than 70 percent of domestic equity managers, 74 percent of global funds, 70 percent of international funds, 45% of international small-cap funds and 68 percent of emerging markets funds underperformed their benchmarks.
If these are the dismal results of the best stock pickers in the world, with all of the resources available to them, do you really think you and your broker can do better?
The Takeaway
Unless you are fortunate enough to own one of the unique French insurance agreements that permit you to buy stocks at yesterday's prices when they have increased in value, trying to "beat the market" is a loser's game.
As noted by my colleague, Larry Swedroe, and his co-author, Andrew Berkin, in their book, "The Incredible Shrinking Alpha," active management is "the triumph of hype, hope and marketing over wisdom and experience."
It doesn't work.
Daniel Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."