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STANDUP Advice: Science Deniers

John J. De Goey, CFP
0 Comments|August 17, 2007

The science says one thing, while the financial services industry says another.
The science says one thing, while the financial services industry says another.

I just finished reading a cover story in Newsweek entitled "Global Warming is a Hoax*". Of course, once one reads the "*" referenced at the bottom of the cover page, one quickly discovers that the remainder of the title ("Or so claim well-funded naysayers who still reject the overwhelming evidence of climate change") is the real message. The article itself is entitled "The Denial Machine." After reading it, I couldn't help but think about the parallels to the Canadian mutual fund industry.

As with climate change, virtually every stitch of verified and peer reviewed evidence on the subject of value (and therefore the utility) of active management shows that it doesn't work. In spite of this, the mutual fund industry (with over $700 billion in total assets in Canada alone) continues to promote itself as if it does. Well-funded naysayers indeed.

Recently, I've come to refer to myself as the "Al Gore of the financial services industry." In fact, the subtitle of my book calling for more professionalism is "How the financial services industry hides the ugly truth." Adjectives aside, it does not matter if the topic is depicted as inconvenient, ugly, fat, purple or anything else. What really matters to our valued clients is the subject in question. The noun. You know- truth.

Forgive me, because I know this sounds awfully forward, but I sometimes feel as if I'm going through life with colleagues who are the modern-day equivalents of the once-thriving flat earth society. If one were to honestly believe that active management is sensible management in spite of the mountain of independent research to the contrary, wouldn't that person at least have the decency to admit that it is the minority viewpoint?

What if you needed open-heart surgery and your surgeon favoured a method that ran contrary to 99% of the thinking of medical evidence, but performed that type of surgery any way- without your prior consent and without even telling you that his was a minority viewpoint?

The perversity of the situation amazes me. Here we have a fact pattern that demonstrates the clear unlikelihood of outperformance as a result of choosing more costly actively managed products as compared to lower-cost passive ones- with the vast majority of advisors nonetheless recommending improbable-to-succeed, high-cost active types of funds to their clients. They do this while sanctimoniously insisting that they are committed to transparency and disclosure and that they "put their clients' interests first."

Of course, it should be noted that just because something is unlikely doesn't mean it is impossible. Virtually every day, someone somewhere wins a lottery, for instance. It should also be noted that just because something is technically possible, that doesn't mean it would be prudent to undertake such an improbable thing (or to counsel someone to undertake such an improbable thing).

The definitive study on the subject of mutual fund performance (there have been dozens of lesser studies before and since) was done by Mark Carhart in 1997 and is entitled "On Persistence in Mutual Fund Performance." It shows that top quartile funds end up about evenly distributed throughout all four quartiles down the road.

This concept is routinely disclaimed in prospectuses the world over when funds note that past performance cannot be relied upon for future results. Obviously, people can't suck and blow at the same time. If past performance can't be relied upon, then people should stop relying on it. If it can be relied upon, then there ought to be some evidence to support that idea.

In spite of this, most advisors I know claim that they can reliably identify outperformers in advance- even as the scientific evidence suggests otherwise and even though the products they recommend disclaim that proposition.

Even with all the web sites, star-rating services, proprietary software and mainstream media articles dedicated to the subject, no one has yet devised a reliable way to identify mutual funds with superior performance in advance. This should be intuitively obvious. If there actually was a way to reliably identify the best funds in advance, everyone would invest in those funds exclusively. Since there are hundreds of billions of dollars invested in fourth quartile funds in Canada, this is obviously not the case.

John J. De Goey, CFP is a Senior Financial Advisor with Burgeonvest Securities Limited (BSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BSL.

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