Does Active Management Work Better In Inefficient Markets?

A commonly held belief in the investment world is that active management works better in inefficient markets where there is less information available (e.g. small cap, international, emerging markets, etc.).  The theory usually suggests that this market inefficiency creates opportunities for managers, through superior security selection, to achieve outperformance.

First, we know of no statistical or empirical data that supports this commonly held belief.  Here is a discussion with Kenneth French (economics professor at Dartmouth) where he discusses this very topic.

In addition, if this argument were true, you would expect to see Small Cap, International and Emerging Market managers outperform their benchmark indices due to the perceived inefficiencies in these markets.  Here is the actual data from the Mid-Year 2012 S&P Indices Versus Active Funds Scorecard (SPIVA):






Interestingly, the best performing asset class against its benchmark index was large cap US stocks.  Since most would consider this to be the most efficient asset class of the four, the argument that active management is desirable within inefficient markets is not supported by the data.


Challenging Conventional Wisdom on the Federal Debt

The conventional wisdom says that our current deficit is out of control and is leading to all sorts of economic problems.  When we look at the data, this is hardly true.  Interest payments on debt as a percentage of GDP is less than 1.5%, which is some of the lowest levels since the 1970s:

FRED Graph


 This is because of ultra low interest rates and the shrinking of the deficit we’ve seen over the past several years.  Now, this doesn’t mean things are all clear ahead.  Rising interest rates could reverse this pattern quickly which is why this is still something the country needs to deal with over the comings years, but the idea that our debt and deficit has created a crisis is just untrue.  As investors it is important for us to make decisions based on facts, not talking points we may hear on TV which is promoting someone’s agenda.  

Morningstar Fund Rankings

Morningstar’s new fund rankings, supposedly predicting future performance of funds, has one year of data we can look at to see how they are doing.  Because they claim an entire market cycle must be completed before they can judge their analysis it is hard to tell how they are doing, but the Wall Street Rant Blog has a good analysis:

“The Analyst Rating is based on the analyst’s conviction in the fund’s ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years.

Now it should be clear that these ratings are longer-term in nature so take the following breakdown with a grain of salt but I said I would follow-up on these so I am.

First lets start with a review of what the distribution of Morningstar’s Analyst Ratings looked like at the start of 2012 (click on the images to enlarge):


While the distribution of ratings has gotten a little better it remains a mystery why Morningstar has an allergic reaction to assigning negative ratings. As of the start of 2013 they have now rated 1069 funds but only 52 (or less then 5%) have negative ratings. Although the neutral ratings have increased to 28%, Bronze to 25%, Silver is down to 24% and Gold down to about 18%.

Without further ado, below is how the rated funds performed in 2012. These only include funds rated at the start of 2012:

Mstar Analyst Rating Performance 2012

Not much really stands out after the first year. While their was a slight positive result for Gold and Silver rated funds, Neutral rated funds did even better. As for Bronze and Negative rated funds, outperformance was pretty much a coin flip.

Below is the Average Rank for each, as you can see Neutral rated funds performed the best and Negatively rated funds performed the worst.

MStar Rank 2012

Take this for what it’s worth, which at this point is not much because full market cycles are indeed a better measuring stick. For instance, in 1999 and 2006/2007 a lot of bad managers did good thinking the unsustainable was in fact sustainable while a lot of good managers did bad as they realized irrationality when they saw it. However, this is at least a starting point for looking at the performance of these Analyst Ratings. 

 Source:  Wall Street Rant Blog


Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.