Even though small-cap stocks broke their winning streak last week amid fears of a September, “calendar anomaly” pullback, the broad small-cap indexes still saw gains for the week. The Russell 2000 closed up 4.05% for the week, despite losses of .22% on Friday. For September, through 9/11/09, the Russell 2000 has returned 3.76%. Year-to-date, the Russell 2000 is up 17.34% (ending 9/11/09). That includes the -32.14% loss for the Russell 2000 from January 2, 2009 through March 9, 2009. Most impressive, however, is that from 2009’s current bottom (3/9/09) to present (9/11/09), the Russell 2000 has returned an astounding 72.92%. The small-cap indexes may have snapped their 6-day consecutive winning streak, but this is inconsequential in the bigger picture.

The above numbers illustrate several points. Perhaps most importantly, the numbers show the volatility that we’ve experienced in 2009. High volatility is closely, and correctly associated with negative returns, but high volatility also provides the opportunity for great positive returns. If one timed their exit and reentry into the Russell 2000, how much of the almost 73% would they have missed? On a total return basis, the best method of investing is also the disciplined method - despite it also being perhaps the most boring method.

Based on a WSJ article by Donna Kardos Yesalavich.

When faced with the mounting evidence supporting indexing as a superior investment approach relative to an active approach, an investor that follows an active approach may state something along the lines of: “I recognize it is tough to beat the market in highly liquid securities where all information is known BUT (always a BUT) … there are certain areas of the market that are more inefficient and therefore allows a more seasoned investor to spot bargains.” The inefficient areas being referred to usually include small cap and emerging market asset classes. While on the surface this makes sense and sounds like the investor is being open-minded in willing to concede his active approach in certain “more efficient areas” to indexing, the subsequent returns do not bear this out. The results for active managers are just as bad if not worst for the perceived less efficient areas of the market than the more efficient areas.

Barron’s recently featured an article, Passive Portfolios’ Emergence, that details the continual inability of active managers outperforming an emerging market index portfolio over the short and long term. To quote:

“The move into index funds has also proved smart. Over the one, three and five years through May, emerging-markets funds on average lagged behind the benchmark MSCI Emerging Markets Index-over the long haul, by a meaningful two to three percentage points a year.”

Underperforming the markets are the equivalent of leaving money on the table, and when Emerging Markets return over 36% as they did for this past quarter, we need to make sure we capture those returns.

After what investors have experienced over the last 18 months or so, it is natural to look around and determine if the investment philosophy guiding your portfolio is a proper one. It seems institutions, the proverbial 800-lb gorillas, are moving away from active managers.

The Wall Street Journal published a story, Active Managers Get the Cold Shoulder, on Monday indicating that institutions are questioning the benefit (or lack of benefit) of an active management approach to stock selection.

A quote that easily jumps out is: “Active managers have not given us the added performance in a down market that we hoped for.” These funds can hire anyone they desire and they are backing away from the active manager option.

As a quick review, active managers are those that try and find under-valued securities and insist that the stock is mispriced. They will profit from their purchase when market participants eventually come to their senses and provide a higher value to that stock relative to the overall value of the stock market. These active investors also take into consideration macro level events and surmise that the markets have or have not reflected these events properly in their prices and hence take anticipatory market positions.

A passive or structured investment approach takes a completely different position. It is based on the premise that all known information is already reflected in a stock’s price and even though new/unforeseen events may recalibrate the stock’s price significantly (i.e., volatility) an investor cannot take the known information and consistently use it to outperform another investor.

I have pointed out in our blog the performance shortcomings of an active approach relative to a structured investment approach. See entries on Active Manager performance and Hedge Funds.

We embrace this structured/passive approach. And it seems, based on the article, so are institutional investors with increasing frequency.

On my drive home from work, I find myself listening to CNBC’s Fast Money because I realize that many of our clients and prospects receive this type of advice on a regular basis and it makes sense to try to keep abreast of popular investment advice.

After the rather dramatic rise in stock prices over the previous month and a half, the focus of these shows seem to be devoted to detecting the next correction, determining the precipitous fate of the dollar, and the extent of any upcoming inflation.

The show Fast Money epitomizes this. After all according to CNBC, these experts “give you the information normally reserved for the Wall Street trading floor, enabling you to make decisions that can make you money.” Well before paying much attention to what they think is next for the market, let’s see how the cast of Fast Money has done. A firm CXO Advisory Group did the heavy lifting for us. This is what they had to say:

The Fast Money experts have on average offered no “fast money.” Average raw cumulative returns for expert picks (black line) are negative for all weeks over the 13-week test horizon (before trading frictions).

The experts as a group perform very similarly to contemporaneous investments in SPY, an S&P 500 proxy (green line) on a cumulative return basis over nearly all of the 13-week test horizon.

The next chart depicts the average raw cumulative returns for the 188 long and 24 short picks of the Fast Money experts. (Short picks are investments that they feel will lose value so they bet against them.) The short picks include six recommendations to buy inverse funds. The long positions by themselves have underperformed SPY over most of the 13-week test period and indicate no stock picking ability.

The short positions alone generate positive cumulative returns for most of the 13 weeks in the test period. (This is the exact opposite of what they wanted.) Declines in the broad stock market over parts of the test period tend to aid the performance of short positions. However, as seen in the previous graph, the short recommendations do not make the experts outperform the overall stock market.

Can we compare the stock picking abilities of individual Fast Money experts?

None of the experts have generated attractive raw returns. In summary, the Fast Money experts as a group probably do not offer fast money with their stock picks, and their stock-picking ability as a group is unimpressive.

It seems to me that the Real Fast Money is actually represented by the general market portfolio. This represents the aggregate investments by all  investors and reflects every-one’s best estimate of how the market should be priced.

And while buying a market portfolio may seem pedestrian and its recommendation to do so will not be able to sustain an hourly trading show, it remains a better option.

As I am quick to point out how most investors fail to outperform a given market, I want to bring to your attention a group of investors that decidedly outperformed the markets and investment professionals.

Recently, a group of investors doubled their money. The article maintains that “they were able to manage their portfolio - in the middle of one of the worst recessions in history - better than most of Wall Street!”

How they did it?
“What we did was just take a risk with the financials - it was beat up at the time, … And we decided to take a risk and see if it would make money - which we did.”

“You just gotta watch the market and watch how it’s going,” Bailey explained. “When it goes up, you take a risk and buy shorts instead of long.”

Who are these investors?
“A team of fifth graders at the Tullar Elementary School in Neenah, Wisconsin, won the state-wide Wisconsin Stock Market Game.” (Want to Make Money on Stocks? Ask a Fifth Grader!)

Will you see them on a nightly business show?
Probably not.

If they had been “investment professionals,” with the same results, would they be making the rounds on the “Mad Money” type of shows?
Possibly.

If stock picking was truly an endeavor based on skill rather than luck you would not see a group of 5th graders outperforming other professionals.

Could you imagine a group of 5th graders building better bridges than trained engineers?

I just saw a commercial today that essentially claimed, “When stocks go up you can sit back and relax but when stocks are volatile you really need an expert …” Well let’s see how that would have played out over this current market cycle. If there was ever a time to discover the “value added” help from the experts it would have been over the last 5 year stretch.

According to Standard and Poor’s most recent Index vs Active Fund Scorecard, more than 70% of all actively managed U.S. equity mutual funds (i.e., funds that select stocks in an effort to outperform a corresponding index of stocks) trailed their benchmarks for the five years ending 2008.

The new report shows that 71.9% of actively managed large-cap funds trailed the S&P 500; 75.9% of actively managed mid-cap funds trailed the S&P MidCap 400; and a stunning 85.5% of actively managed small-cap funds trailed the S&P SmallCap 600.

Actively managed funds also did poorly on a one-year view: 54% of large-cap funds trailed the S&P 500; 75% of mid-cap funds trailed the S&P MidCap 400; and 84% of small-cap funds trailed the S&P SmallCap 600.

International funds did just as poorly, on a one- and five-year basis. Sixty-three percent of global funds trailed the S&P Global 1200 on a five-year basis; 84% of international funds trailed the S&P 700; 59% of international small-cap funds trailed the S&P Developed Ex-US Small-Cap; and 90% of emerging market funds trailed the S&P/IFCI Composite.

“The belief that bear markets strongly favor active management is a myth,” said Srikant Dash, global head of Research & Design at Standard & Poor’s.

It would be nice if we could require commercials making superior investment claims show the above information.

Are we well positioned from an investment strategy standpoint for the next market stage?

There are essentially two forms of investment management. Active managers are those that try and find under-valued securities and insist that the stock is mispriced. They will profit from their purchase when market participants eventually come to their senses and provide a higher value to that stock relative to the overall value of the stock market. These active investors also take into consideration macro level events and surmise that the markets have or have not reflected these events properly in their prices and hence take anticipatory market positions.

A passive or structured investment approach takes a completely different position. It is based on the premise that all known information is already reflected in a stock’s price and even though new/unforeseen events may recalibrate the stock’s price significantly (i.e., volatility) an investor cannot take the known information and consistently use it to outperform another investor. We embrace this approach.

Recently, the NY Times highlighted a published study in Economics & Portfolio Strategy by Mark Kritzman. The study supports the standard conclusion that investing in index funds provide better net returns than hedge funds and actively managed mutual funds. This strategy is reflected in the structured, multiple-asset class approach that we follow.

Taking into consideration variables such as taxes, premium fees, turnover, and transaction costs that are significantly more onerous in hedge funds and active managers, an active mutual fund would have to return 13.5% a year and a hedge fund 19% a year to simply keep pace with an annualized passive return of 10%.

What are the odds of finding a manager that can outperform the markets by such an extreme margin? According to Russell Wermers, a finance professor out of the University if Maryland, “next to zero.” He also concludes that it was “exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone.”

Kritzman concludes that “it is very hard, if not impossible to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And those that attempt this are “deluding themselves.” What about in a tax-sheltered accounts? “Even in a tax-sheltered account, the odds of beating the index fund are still quite poor.”

So are we positioned from an investment philosophy standpoint for the next stage in the markets? The evidence indicates as much.

A Wall Street Journal article recently devoted a front page story to the only active manager out of 8200 diversified US stock mutual fund managers that ended 2008 with a positive return. This manager, Thomas Forester, of the $70 million dollar Forester Value Fund, returned .4% for the year. (Interesting side story is that his wife wanted him to close his fund last year if he couldn’t improve his returns from previous years.)

While some readers of the Journal may have thought, “Wow how do I get in on that?” What is of more interest to me is that if there was ever a year where market forecasting could have come in handy, it would have been in 2008. No other fund came in above zero and unfortunately, the average US fund lost -39% last year compared to a US market drop of -37%.

What are the odds that only one out of the 8200 self-proclaimed markets beaters was essentially flat for 2008? By chance alone, you would have thought some other fund manager could have been out in front of this tsunami.

 Why is it again that we listen to these managers when they are guests on CNBC for their best investment ideas or their views on what is going to happen next?