Morningstar yesterday advised that “deciding whether to buy or keep a fund that was once a top performer can be tricky.” In fact, that’s understating the challenge if you consider that managing a portfolio of active managers requires two skills: predicting when market-beating returns are likely to prevail and deciding when the bloom has fallen from the rose.

The primary reason for using active managers is the pursuit of market-beating results, or alpha. Of course, alpha can be negative or positive, meaning that while it’s easy to be an active manager, it’s a lot tougher to routinely deliver positive alpha. Yes, it can be done, but it’s not easy, as the historical record tells us in no uncertain terms. And just as it’s hard for active managers to excel, there’s little reason to expect that the average investor is any better at picking top managers (and avoiding the dogs) on a consistent basis over time.
Indeed, choosing the top active managers is akin to selecting the best securities. It’s not surprising to find that most efforts on this front end up with mediocre results, at best. The damage from taxes and trading costs is one reason. Another is that the future’s uncertain. There’s also the necessary challenge of forecasting betas. Focusing on active management doesn’t give you a pass from developing intuition about the outlook for beta, or the trend in the underlying market. It would hardly be productive to identify a stellar small-cap value equity manager, for instance, without making a forecast about the general outlook for small-cap value stocks.
The dirty little secret of using active managers is that you’ll still need to run the analysis on betas. That means that managing a multi-asset class portfolio with active managers requires twice the work, at least. For most investors, the challenge is likely to be insurmountable.
Even for professionals overall, the track record for publicly traded funds that engage in some form of multi-asset class investing is just what you’d expect overall: average. I crunched the numbers on 900-plus funds in Morningstar Principia’s database with at least 10 years of history that are labeled conservative allocation, moderate allocation and world allocation. I excluded portfolios that employ short positions or leverage. This takes in a lot of territory, but the common denominator is that most if not all of these portfolios engage in some form of managing a multi-asset class strategy. It’s an imperfect proxy for multi-asset class portfolios, but it offers a rough estimate of real-world track records in this niche.
The best performer in this group for the decade through August 31, 2010 posted a stunning 17% annualized total return. There was almost as much drama in the bottom performer, albeit in reverse: an annualized 11%-a-year loss! Those are extreme outliers, and so they mask the returns posted for the bulk of these funds. For instance, 95% of the portfolios reported a gain of 6% or less.
In fact, a passive, unmanaged approach to buying all the major asset classes, weighted by market values, outperformed about 70% of the 900-plus funds. The Global Market Index (GMI), a proprietary benchmark I use on the pages of The Beta Investment Report, generated a 3.4% annualized total return for the 10 years through this past August. Mindlessly rebalancing GMI every December 31 boosted GMI’s return to 4.4%. Not bad for a know-nothing strategy that buys and holds all the major asset classes in an asset allocation chassis that simply accepts Mr. Market’s weighing scheme.
Is GMI’s modestly above-average performance surprising relative to the 900-plus actively managed funds holding multiple asset classes? No, not really. Alpha, after all, is a zero-sum game. Positive alpha is financed by negative alpha. In other words, winners exist because of losers. Beta is usually in the middle, or perhaps slightly above average, thanks to higher taxes and trading costs that continually harass the pursuit of alpha. True for individual markets, true for a broad mix of asset classes.
This isn’t necessarily an argument for avoiding active managers. Depending on the market, your strategy, your skill and a host of other factors, you may decide to pursue alpha. Indeed, the overwhelming majority of investors do so. But there are practical limits to boosting return using actively managed funds as your asset allocation broadens. It’s one thing to say that you’re going to own only, say, U.S. stocks and spend all of your research efforts focused on choosing a top manager in that corner. It’s quite another challenge to own five, 10 or 20 asset classes and attempt to maintain exposure to the leading active managers in each bucket while also managing the overall mix with a deft hand.
Even if you decide to target betas exclusively—i.e., use ETFs, ETNs and index mutual funds—your task will be quite difficult if you plan on engaging in some degree of active asset allocation. In fact, if you own active managers you’ll still have to do all the heavy lifting when it comes to analyzing betas. The only difference with choosing actively managed funds is that you’ll need to be correct on forecasting betas and alphas to warrant the additional effort. That sounds like a full-time job, which means that the odds look slim for winning the money game with so many moving parts if you’re crunching the numbers in your spare time.
For most investors with a broad asset allocation strategy, a better strategy is using mostly index funds and ETFs and reserving active managers to a handful of funds where you’re confident that the manager can add value over time. When in doubt, index. One of the benefits of using betas is that you have a high degree of confidence that you’ll capture the lion’s share of the risk/reward profile of the target market and that you’ll pay a low cost in the process. That’s a strong hand to play to tip the odds of success in your favor.
Meanwhile, owning too many actively managed funds eventually runs the risk of delivering what you’re desperately trying to avoid with that strategy: earning beta. In that case, you’ll be paying actively managed prices for average performance. The only thing worse than beta is high-priced beta. That’s what most investors end up with in the long run, despite all the frantic efforts to engineer superior results. Fortunately, that’s one risk in money management that’s easily avoided.