The Two Studies Your Broker Hopes You'll Never Read

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William F. Sharpe, an emeritus professor of finance at Stanford University's Graduate School of Business, is best known for winning the 1990 Nobel Prize in Economic Sciences. In finance circles, he is famous as one of the originators of the capital asset pricing model and the "Sharpe ratio", which measures the excess return per unit in an investment asset.In 1991, Sharpe published a paper titled The Arithmetic of Active Management. The paper discusses the "active investor" (defined as "one who is not passive and whose portfolio "will differ from that of passive managers at some or all times") and the "passive investor" (defined as one who always holds every security from a designated market [like the S&P 500], with each represented in the same manner as in the market.).

%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%% Most brokers and advisers are "active managers" who recommend portfolios of stocks, or actively managed mutual funds, they believe will "beat the markets." When they recommend actively managed mutual funds, they often do so based on the Morningstar rating of the fund ("This fund gets 5 stars from Morningstar!") or the past performance of the fund manager. Sound familiar?

According to an article by Larry Swedroe, "...active investors transfer about $80 billion annually from their own wallets to the purveyors of actively managed products and market makers."

And Sharpe's conclusion on active investing, which was startling in 1991, remains so today. He wrote: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

In plain English, this means "market beating" brokers are engaging in conduct which will cause active investors to underperform passive investors as a whole.

"A Futile Search for Superior Returns"

In a separate 2008 study, Kenneth French, a professor of finance at the Tuck School of Business at Dartmouth College, quantified the cost to investors who followed the advice of active managers. French concluded: "On average, active investors spend 0.67% of the total market cap each year on what, in aggregate, is a futile search for superior returns."

The bottom line of these two studies is that investors who rely on the advice of their "market beating" brokers may pay dearly.

The evidence supporting this conclusion is so overwhelming you have to wonder how these brokers and advisers get away with recommending actively managed portfolios of stocks and mutual funds without disclosing to investors they are likely to obtain superior returns using a passive strategy.

There is a federal statute, known as Rule 10b-5, which makes it unlawful to mislead investors when selling them securities. When a broker tells a client to buy an actively managed mutual fund, he should disclose the likely underperformance of that investment when compared to an index fund of comparable risk. Whether or not the failure to do so violates Rule 10b-5, investors are entitled to this information so they can make an intelligent decision.

There is a reason why your broker or adviser may not want you to read the Sharpe and French studies. It's the same reason you should read them carefully and draw your own conclusions.
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