Millions of people around the world invest in actively managed mutual funds, believing fund managers can find enough hot stocks to supercharge results. But others scoff at the idea, pointing to studies showing the average managed fund trails its benchmark index over time.
While some managers do exceptionally well year after year, it is not clear whether the reason is skill or luck. With enough people flipping coins, some will flip a string of heads, the index advocates say. They prefer passive management, in which a fund simply buys the stocks in its benchmark index and holds them for the long term, minimizing the costs and fees that chew into returns at managed funds.
Most studies of active versus passive managing have focused on long-term results, looking at how a class of managed funds performs relative to its benchmark over periods of one to ten years. A managed fund containing stocks in large companies, for example, is typically compared to the Standard & Poor's 500 index, which consists of the 500 largest U.S. stocks.
But this approach fails to consider the element of risk, says Jessica A. Wachter, a finance professor at Wharton. "The question is, how do you properly risk-adjust?" she asks. Since a managed fund's holdings are not the same as those in its benchmark index, the two portfolios' level of risk is not the same. If the managed fund were to hold more small-company stocks than the index, for instance, it would be expected to beat the index when those risky small stocks did exceptionally well, and to trail when they did poorly. Comparing the two funds' results over any given period does not reveal whether the successful active manager really had an eye for good stocks or simply stumbled upon a group that happened to do well over that period.
This dilemma is known as the "joint-hypothesis problem," since there is more than one possible explanation for the research results.
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