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Most fund managers are underperforming in 2012

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Thus far in 2012, active managers of mutual funds have generally underperformed their market benchmarks. In fact, industry figures show as many as 75 to 80 percent of actively managed portfolios have delivered lower after-fee returns than passively managed index funds so far this year.

Investing in a mutual fund which is actively managed by an investment manager should be based on certain assumptions. For example, the incremental return expected to be generated by the investment manager should be in excess of the fee charged by that manager. Additionally, the investment manager is generally hired to perform a certain set of activities and manage the portfolio of assets within a predetermined set of guidelines. These guidelines generally outline the types of assets which can be purchased, the index against which the investment manager’s performance will be judged and the types of investment risks the asset manager will employ in the portfolio.

If the decision has been made to allocate funds to a portfolio managed by a professional investment manager, one of the significant additional decisions to make is what sort of risk is contemplated for the allocated funds. For many portfolios, one of the most significant contributors to the risk within the portfolio is the underlying market exposure imbedded in the assets managed. This exposure to the behavior to some portion of the underlying market is called “beta” exposure.

An asset portfolio which behaved exactly like the passive index against which its performance is compared would be said to have a beta of one. In this example, the portfolio’s value would go up and down exactly like the comparative market index.

Paying an investment manager to deliver portfolio performance which mirrors the performance of a passive index, thus delivering beta equal to the relevant portion of the market, would insure an after-fee return less than that of the passive index. To deliver a total return above what can be earned by investing in a portfolio which mirrors the performance of a market index, the investment manager must create incremental portfolio returns which more than compensate for the management fees charged by the manager.

Investment styles go in and out of favor as market conditions change. A relatively small subset of investment managers can outperform their relevant passive indexes over a range of market cycles.

Kirby Brown is the CEO of Beneficial Financial Group in Salt Lake City.