Active mutual funds have taken it on the chin recently. But Chief Investment Officer Bryan Hinmon still believes in their ability to generate winning investments over the long run.

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10-second summary: Why should you consider active investing?
     * Simply avoiding a few of the worst performing stocks boosts returns greatly.
     * Portfolio managers can add value by picking stocks!
Estimated reading time: 6 minutes

 

Dear Fellow Fool Funds shareholder:

Lately, not a day goes by in which I’m not bombarded with news stories and data that claim active investing has both feet in the grave and passive investing is holding the shovel. Images such as the following chart make this chatter hard to ignore.

I’ll go on record and say that I think the adoption of passive investing is great for our world and that most investors are very well served by a sensibly designed asset allocation that features passive investing options. This may sound like heresy coming from a portfolio manager of actively managed funds. And it may make me more likely to get fired. Still, I believe it to my core.

But that’s not all that I believe. 

I believe a sensible, disciplined approach to active investing can win over time and offer a better path to investing success than passive investing.

Boom. Well, maybe not “boom” quite yet. Below, I'd like to make the case for why I think active investing could likely win over time.

The Capitalism Distribution – Avoiding the Bad Stuff

The first part of my argument starts with my belief that active management can help reduce exposure to the "bad" stocks out there. And believe me, there are a LOT of bad stocks out there. Blackstar Funds studied the performance of 8,000 domestic stocks over 25 years. They found that nearly two out of every three stocks underperformed the Russell 3000 (annualized, over the entire time period). If you chose a stock at random, your likelihood of choosing one of the 1,498 stocks in the bucket of worst-performing returns was greater than choosing a stock in any of the five top-performing-return buckets. Because capitalism is a brutal regulating force on economic profits and therefore stock returns, there are a lot of losers.

Source: Blackstar Funds, ”The Capitalism Distribution"

So how much benefit could there be if active management could simply avoid the terrible stocks? Well, Franklin Templeton Investments took a stab at answering this question and found that consistently avoiding just the bottom five stocks improved average annual total returns from 8.19% per year to 10.65% per year. That's a 30% increase!

Source: Franklin Templeton Investments, ”What Matters Most.”

Our takeaway: the effort involved to avoid the worst-performing stocks sure seems worth it. Our active management posits that a sensible way to do this is, first, to focus on qualitatively and quantitatively measuring company quality, and second, to make sure we buy and hold high quality at reasonable prices. Doing these two things well, in a disciplined and repeatable fashion, should help us avoid the worst.

 

Picking Stocks – Getting More of the Good Stuff

I hear a lot about active mutual funds underperforming passive indexes. I also hear the logical conclusions being drawn that this means active portfolio managers are unskilled (in other words, they can’t pick stocks). This is untrue. There is a sizeable body of research (I’ll forgive all of you for not spending your evenings and weekends reading academic papers and trade journals) that proves otherwise.

My favorite work on this subject comes from a former professor, and now professional investor, named C. Thomas Howard. He shows that most active portfolio managers are skilled at picking stocks, but other factors, such as over-diversification and asset bloat (which he calls “portfolio drag”), reduce the benefit of good stock picking.

The first point Howard makes is that active portfolio managers are, in fact, skilled. He analyzed more than 4,000 mutual funds and 44 million monthly holding period returns to show (as several other researchers have shown) how top holdings generate alpha.

Source: ”Why Most Equity Mutual Funds Underperform and How to Identify Those That Outperform.“ Howard, C. Thomas. Jan. 26, 2016.

The problem, as Howard sees it, is that beyond a manager’s best ideas, the rest are mediocre at best and detract from performance. He provides a few reasons he believes managers simply don’t fix this problem. First, most managers have an incentive to make their funds as large as possible – they make more money that way. A large asset base can make it difficult to invest only in your best ideas. Second, he suggests that managing a high-conviction portfolio runs the risk of making the manager look like a bozo if he or she is wrong. It may help to look like the index, and one can do that by building a portfolio with a ton of stocks.

Source: ”Why Most Equity Mutual Funds Underperform and How to Identify Those That Outperform.” Howard, C. Thomas. Jan. 26, 2016.

Howard provides a nice formula for reducing career risk: match sector and size weightings + own a ton of stocks = get paid.

Our takeaway: we are happy to be different. If you doubt that, take a moment to remember that we call ourselves Fools publicly. Also remember that we named our maiden fund the Independence Fund. We revel in independent thought and have always said we will look different from our benchmark. We believe the surest way to great investing returns is to own a focused portfolio of high-quality businesses purchased at reasonable prices. We’re OK looking like bozos in the short term to achieve great results in the long term. We’re also sensitive to the size of our funds (they are small, so we can manage focused portfolios) and to how we give our team incentive (it is not based on managing more and more assets).

 

What It Takes to Win

I can’t promise that active investing will produce winning investment results over the long term. I can promise that passive index investing will produce below-average investment results over the long term (indexes provide you with average, less a fee). Our team believes that the chance at winning investment results is worth taking, especially believing that we’ve stacked the deck in our favor of long-term favorable results by focusing on businesses of impeccable quality, being mindful of the price we pay, keeping our focus on a few great ideas, and being comfortable looking different from the rest of the world.

It seems the investing world and the media (dare I say almost nobody) agrees with us on this. And that, fellow shareholder, makes me feel as if we just may have something here.

Past performance does not guarantee future results. There can be no guarantee that any strategy (risk management or otherwise) will be successful. All investing involves risk, including potential loss of principal. Securities in a Fund may not match those in an index and performance of the Fund will differ. You cannot invest directly into an index.

Onward,

 

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Bryan Hinmon

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