Will I Have to Eat My Words?

Earlier this week, I stood in front of a microphone and boomed this out to a large audience:

“You will not find an independent study anywhere, suggesting that you have decent odds selecting actively managed mutual funds that will beat the market indexes”

Then I went on to suggest that after reading more than 300 personal finance books, I’ve never seen a book suggest this either.

But since then, just for kicks, I went for a search.  And the search ended when I found Louis Lowenstein’s exceptional book, The Investor’s Dilemma.  A professor at Columbia Law School, he penned the book in 2008 with one startling assertion:  You can find actively managed mutual funds that beat the markets.

First of all, let’s be clear about one thing.  He’s not a fan of the actively managed mutual fund industry.  In fact, if he could stuff it in a sack with a bunch of rocks, he’d probably toss the whole industry into a deep lake.  He’d let the fund managers, salespeople,  and their owners thrash it out in that bag for a while, but he’d eventually yank them out and hang them out to dry, before assigning them to roadside cleanup.  The image is mine, but the abhorrence for the industry is definitely Lowenstein’s. 

Rightfully, he sees most actively managed fund companies as self-serving entities that promise more than they can deliver.  They have no consideration for their investors’ taxes (because they churn their holdings) and they grow larger and larger—accentuating their inefficiency—as they collect more and more assets from uneducated investors who are almost certain to underperform the indexes.

Lowenstein sees index funds as a great alternative to most actively managed funds.  But he doesn’t stop there.  He’s out to prove that the Holy Grails of the investment world do exist, and that you can find them.  You can find funds that beat the indexes, he suggests.

First, he eliminates the mutual fund families that most of us have heard of:

The American Funds get skewered by Lowenstein for their “pay to play” scandals and their unfair remunerations, given to brokers who sell their funds.  The fact that the fund company grows like a behemoth without closing its larger funds to new investors showcases that The American Funds company isn’t out for the investor—it’s out for itself.  The larger a specific mutual fund grows (from salespeople stuffing investors’ money into them) the less efficient those funds are going to be, going forward.

Fidelity doesn’t escape the same wrath, for the same basic reasons.

He goes on to hammer publically traded fund companies (as he should) that have a tug-o-war battle going on between what’s best for their companies’ investors, and what’s best for those who invest in the funds.  Who wins that battle?  You’re naive to think that their mutual fund investors do. Fiduciary duties are jeopardized at the expense of the funds’ investors, of course.  Some of these fund companies include Alliance Capital, Ameriprise Financial, Eaton Vance, Federated, Franklin Resources, Janus, Neveen, T. Rowe Price and Waddell & Reed.  Each of these fund companies trade on the stock market.  Trust me, it’s better to own shares in their stocks than it is to own their funds.

Yet Lowenstein thinks he can pick funds that beat the market

His arguments, in the book, are compelling.  If you can find value oriented fund managers who are patient, disciplined, with relative low fee structures, low portfolio turnover, who own shares in their funds, who have reputations for closing large funds to new investors when they grow unwieldy….then you can find funds that trounce the indexes.

He gave 10 such examples that have crushed the market indexes.  And as further support for these funds, he wanted to show how smart managers could sidestep falling markets or market silliness by choosing carefully selected stocks only, without diversifying into too many individual companies.  Choosing the years between 1999 and 2003, he showcased how each of these funds trounced the S&P 500 index.  Have a look at the list below, from page 26 of his book.

Average Annual Returns:  1999-2003 Annual Return
Clipper Fund +11.9%
FPA Capital +15.29%
First Eagle Global +17.02%
Legg Mason Value +4.43%
Longleaf Partners +10.94%
Mutual Beacon +10.28%
Oak Value +2.63%
Oakmark Select +15.43%
Source Capital +15.22%
Tweedy Browne American Value +4.87
Average Annual Return for the 10 above +10.8%
Return for the S&P 500 Index -0.57%
Average annual advantage over the index +9.43%


My personal dilemma

As many of you know, I have also easily beaten the stock market index—leaving it soundly in my dust over the past decade, after purchasing individual stocks.  My investment club has done the same thing.

But recently, I sold $700,000 worth of individual stocks to fully index my portfolio.  Did I make the wrong move? 

I don’t think so.  No matter what happens, going forward, my investments will be in the 90th percentile, in terms of performance.  The enemy of the great plan is the perfect plan.  Reaching for that perfect plan (at least in the world of investing) is like reaching over the edge of a ravine to pluck a pretty flower.  You might fall.  Do it enough times, and you surely will.  I’d rather have 90% of the cliff’s flowers brought to me each morning, rather than trying to collect all of them by venturing precariously over a railing.

But was Lowenstein on to something?

We know what John Bogle and Burton Malkiel would say, relating to my bolded question.  They would suggest that there’s no way of knowing what funds are going to perform well ahead of time.  True, there will always be funds that beat the market indexes, but these great men suggest that nobody can tell what they’ll be, ahead of time.

Lowenstein says that’s hogwash.

Let’s find out.

The above returns end in the calendar year, 2003.  Lowenstein’s book was published in 2008, so we can assume that these funds probably did very well from 2003 to 2007, or he wouldn’t have included them in his book.  If they had underperformed the markets from 2003 to 2007, somebody would have called him on it.

Now, despite what we assume will be a good run of performances for those funds to the point of Lowenstein’s book’s publication, let’s put those funds to a longer test.

His performances went to the end of 2003.  If we use Morningstar to track their respective performances, how would they have done from January 1, 2004 to today (March 12th, 2011)?

If Lowenstein is right, they would have crushed the S&P 500.  And why not?  From 2004 to 2007 we had a Bull Market.  Stocks everywhere rose exponentially.  But the great money managers of the world could have (so the story goes) saved our money from the precipitous drop of 2008/2009.  They would have sold when they forecasted that the market was going to plunge, or they would have sold on the way down—only to buy their stocks back when the market was at a cheaper level.  That’s what a smart value investor can do, as Lowenstein suggests in his book.  In theory, it seems like an easy way to crush an index that’s hinged 100% to the stock market.

Ready to put his funds to the test?

I’ll relieve some of the tension if you want.  Of the 10 funds lauded by Lowenstein, 7/10 of them lost to the S&P 500 index from January 2004 to March 12, 2011.  This is before taxes.  True, three of them did extraordinarily well, but how are you going to know which of the “Super funds” would rock, if you were trying to forecast that ahead of time.  The book suggests that they are all Superfunds.  Yet 70% of them lost to a simple index fund without a clever manager at the helm.

Here are the results:

Average Annual Returns:  January 2004 to March 12, 2011 Overall return
Clipper Fund +2.5%
First Eagle Global +98%
FPA Capital +92%
Legg Mason Value -32%
Longleaf Partners +36.9%
Mutual Beacon +37.3%
Oak Value (name changed, see ticker RCAPX) +24%
Oakmark Select +34%
Source Capital +76%
Tweedy Browne American Value +41%
Average Annual Return for the 10 above +41.4%
Return for the S&P 500 Index +41.8%
Deficit compared to the index -0.04%

In 2004, there’s no way that you’d know which 3/10 of these funds would beat the market index ahead of time, over the seven following years.

And it’s more depressing than that.  If you bought all of these funds, you would have lost narrowly to the market index before taxes.  But if you owned these funds in a taxable account, you would have lost about 0.25% annually in taxes, relative to the index fund.  I’m being generous to the actively managed funds when assuming a 0.25% annual albatross, compared to the index.  The deficit could end up being much higher than that.   Compound that 0.25% over seven years, and you can add a further 1.7% advantage to the index fund over the performance of the super funds.

Mr. Lowenstein,

By no means am I suggesting that you’re not a bright man.  I love your book, and I plan to commend you personally on it, with a postcard from Singapore.

But could it be a lot harder than you think it is to pick actively managed mutual funds that will beat the market indexes?

no one has more first hand experience helping expat investors

Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School (2nd Ed. Wiley 2017) and The Global Expatriate’s Guide To Investing: From Millionaire Teacher to Millionaire Expat (Wiley 2015). My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I'm happy to comment on your questions. However, please read the Terms of Use, Privacy Policy and the Comments Policy.

You may also like...

7 Responses

  1. worlds best value financial advisor

  2. DIY Investor says:


    As always a great analysis. It always surprises me that it works out. Even if it didn't, it is only a single, short period. The real test is over the long term and investors have very long horizons. Is it worth taking the chance with one's retirement money? Under perform by 1 – 2% over 30 – 40 years and it can have a big impact. Under perform the last few years before retirement, when the portfolio is sizeable, and it can be huge.

    In the last set of data I was interested in doing the calculation excluding FPA Capital at +92% and Legg at -32% which can be considered outliers and noticed you have 9 funds.

    I would put Russel Kinnel, of Morningstar, in also as one who believes active manager funds can profitably be uncovered although he seems to be appreciating more fully the impact of expenses on fund performance over the long term.

    Others interested in this topic will like:


  3. Thanks for the heads-up Robert:

    You might have noticed, if you did the math, that the funds, as an average, didn't perform as well as I claimed they did. That's because I averaged the results of 10 funds, but I skipped one, accidentally, when putting it into the table.

    With the addition of Global Eagle, you'll notice that the math works out now.

    It increased at 17.02% per year from 1999-2003 and overall, it increased by 98% from January 2004 to March 12, 2011. It was the 10th fund in Lowenstein's book.

    Now my numbers add up. And you'll have to change your "outlier"

    But with respect to "outliers", there's this to think about. There will always be a possibility of that outlier in either direction. And they do cancel themselves out somewhat.

    That said, you're right that I'm potentially just lucky that the numbers are in the favour of the indexes over such a short time duration. Over a lengthier period of time, especially after taxes, picking ten funds that will beat the market index is much closer to impossible.

  4. Scott Hutchison says:

    Always great to read and feel the fun you're having with this Andrew. How tempting those cliff flowers are when you're reaching with someone else hand:)

  5. Andrew, one can skew the time line for measuring performance in order to prove a point, beating or getting beaten by the market.

    In my opinion, never say never. If you have gamblers making a living from online poker, then I am certain there are people out there who are beating the market consistently, who they are or how many are they does not matter.

    Here's an easy way to claim your fame. Beat the index for a limited period of time, imagine an investor who doubles his portfolio in 1 or 2 years and then invests in indexed funds at 100%. Because of the initial gap, the said investor can claim beating the market over an x number of years….

    I'd love to read a post from you about a world where every investor puts his dollars in indexed funds (Utopia). Would that create side effects in any way?

    • Hey Mich,

      You're right. There are going to be people who beat a diversified indexed account. After all fees, taxes and the behavioral tendencies most investors suffer from, I'm guessing that roughly 3% of investors will match my personal indexed account over the next 30 years. I don't think it would be much higher than that–especially when considering the bahavorial component of riding trends and then getting stuffed…which most people fall for.

      That said, somebody has to fall in that 3%. But sadly, most people think that 3% applies to them. It's a bit like a thousand swimmers launched from an underwater submarine. There are two caves ahead. One, to the left, has a huge opening, and it opens into an open air cave that a person can climb out of.

      The second cave entrance is tiny. Only a few swimmers will be able to enter it at a time. But inside that cave, there are promises of a few dollars, as well as an air tunnel to the surface. There aren't many dollars–just a few.

      In a rational world, the rational swimmer would swim towards the wider cave. After all, there are thousands of other swimmers in the water. But in the world of investing, most people would metaphorically swim to the cave of promise, with the tiny opening.

      Some people will make it into the narrow cave and collect a few dollars. And those stories of their survival and their tales of finding a $100 bill each will encourage other submarine swimmers to go for it.

      As for the perfect world where everyone indexed…..I don't think that's what I want.

      I think that active management could cost what it used to cost, in the 1940s. It wasn't such a lucrative industry to be in then, and fees were significantly lower than they are today. Plus, we have an added economy of scale now, making the whole show much less expensive to run.

      If the average expense ratio was 0.4% instead of 1.35% (or more for Canadians) then you'd still get the majority of active funds losing to the markets over time, but those that did win would win by larger margins, and those that did lose would lose by smaller margins. If there is such as skill as "stock picking" (which I don't deny there is, completely) then able managers would be rewarded. And investors in able funds would be rewarded. That said, trying to find an index-beating fund would still be a treacherous task because more than half would still fall below the market index's level, because active management, as an aggregate, before all fees, is the market. Add in fees (even small ones) and the vast majority underperform. Add in taxes….phew! Then it gets tougher.

      People aren't wired to index. The vast majority will think they can beat the market. I tend to think that I'm not skilled or fast enough to get into that tiny cave hole–despite having a decent track record as a swimmer. It's easier to go for the sure thing–and beat the vast majority of others who all think they can squeeze into a tiny gap. Having a statistically irrefutable method to beat almost all investment professionals in an incredibly comforting thing for me. For me, it's not worth swimming for that tiny gap. And as my article post points out, it's a futile venture for even the boldest Columbia University professor as well.

  6. I was going to ask about the subsequent performance, but then you got to the punch. Great response in the comments section, too. I don't think it would make sense if everyone started to passively index, but certainly there is a point where they can come into a healthier balance where there is a fair benefit to paying the fees for an actively managed fund.

    I also think that if one focuses on what they have a passion for and have the time to invest their energy into the research then they can also do well. If you are doing it for yourself, then there are no fees to pay other than the time, though if you love it then that's not really a downside. I personally take the "lazy and passive" approach for much of my assets but I see things much the same as you — indexing works, but there is a place for active management too and we could probably get closer to the ideal balance if fees weren't so ridiculous.

Leave a Reply

For your privacy we strongly recommend you do not use your full real name. While your email address will not be published, it may reveal your photo or a recognizable image if it is associated with gravatar.com. It is strongly suggested you do not use a corporate or ISP email address. Before your comment is published you will receive an email asking you to confirm your email address. Select "Notify me of follow-up comments via email" to receive notifications of replies and be able to adjust your subscription. Published comments will not be deleted.

By clicking "Post Comment" you confirm you have read and agree to the conditions on the Legal Page; including the Privacy Policy, the Cookie Policy, and the Comments Policy.  We reserve the right to not publish comments that do not meet guidelines.