Why Even the Best Investors Can't Pick Winning Actively Managed Funds Consistently

What seems like a long time ago, I wrote a piece talking about the impact costs have in determining the success of your investments. The takeaway was that if you wanted to get the best return possible from your investments, you needed to make sure costs (trading costs, taxes, various fees, etc.) were as low as possible. My solution? Index funds.

But others argued (and have kept arguing) that either they or actively traded fund managers can pick out better investments and outperform the "average" (which is supposedly what index funds get you -- more on that later). I argued back that this was not so, but often to no avail. Oh well.

Then I found this piece recently from MSN Money. It details the fall of the mighty Fidelity Magellan, once the premier investment in the mutual fund industry. The article details how Magellan's results have dropped dramatically through the years despite having access to the best investing minds in the world. This story serves to illustrate several issues:

• Even the best minds can't regularly outperform the market.

• If a particular manager does manage to beat the market in the short term, many of them move on to other funds and investors are left without the key ingredient that made their fund a success.

• Even if investors can pick a great manager once, doing it several times in a row is nearly impossible.

• Anyone investing in actively managed funds pays a TON to do so -- far more than what they'll likely earn back.

Let's look at some highlights from the piece -- the first highlighting the inability of anyone to pick a great fund manager:

If Fidelity, with all its savvy and resources, can't pick a winning manager [as evidenced by Magellan's fall], just what do you think the chances are of you or me doing it? What do you think are the chances that the average investment adviser can do it? In fact, the odds are poor, whoever does it.

Then, if you somehow do luck upon a great mutual fund manager, chances are he'll move funds and you'll need to find a new one (in another fund or maybe just hope the new fund manager is good.) How likely is this? Not likely at all:

Worse, picking a fund manager isn't a once-in-a-lifetime decision. It's a decision that has to be made again and again. Fund managers, on average, don't stay at the same fund very long. According to the Morningstar database, for instance, the average duration of all fund managers at a particular fund is only 4.5 years. Restrict your sample to the largest funds -- those with at least $1 billion under management -- and the average tenure rises to 6.6 years.

This means a 30-year-old worker probably will need to make a fund decision six times before retirement and three more times after retirement. Each time he makes that decision, or pays a professional to make that decision, the chances of doing better than an index fund is about 30%. Those aren't very good odds.

In fact, the odds are dismal. The probability of making two good decisions in a row is only 9%. Try to make three good decisions in a row, and the probability of success is only 2.7%. By the fourth decision, the probability of making a winning choice each time is less than 1%.

And not only is it nearly impossible to pick a winning fund manager, but all the time you're trying to do so, you're incurring fees:

Meanwhile, the fee meters are running, transferring billions of dollars from the return on our investments to the financial services industry. This happens year in and year out. The financial services fee machine does incredible damage to retirement security.

And these fees are not inconsequential:

Excessive fees, in other words, can do as much damage as a major bear market. Worse, while the 28% lost in a bad market may eventually be recovered in a rising market, the money lost to a lifetime of excessive expenses is gone forever.

However, there is hope for investors:

Fortunately, there are signs we're beginning to understand that this is a no-win game. Today, eight of the 28 funds that are larger than Magellan are index funds. Money follows performance, and low-expense index funds routinely trump the expensive pride of our fee-bloated financial services industry.

So, it's pretty much a fool's game trying to pick a fund (and manager) that can beat an index fund. Of course you could pick the stocks yourself, but do you really think you can do better than the best, brightest minds that have 70-hours-a-week, full staffs, and millions of dollars available to pick the best investments?

Let's finish with a quick example of how an index fund actually beats the market even though it delivers only "average" results. These aren't actual numbers, but simply serve as an example of a sample year's performance results:

• Return of the market: 10%

• Return of a stock index fund: 10%
• Cost of a stock index fund: 0.1%

• Return of an actively managed stock fund: 10.5%
• Cost of an actively managed stock fund: 1.0%

• Net return of a stock index fund: 9.9%
• Net return of an actively managed stock fund: 9.5%

As you can see, an actively managed fund can still beat an index fund (though many don't, making them even worse investment options) in total return, but once expenses are deducted they underperform when compared to index funds. This is how index funds can "only" deliver the market "average" and still end up beating most active/y managed funds on a net return basis (the measure that counts.)

Comments

[Erik Folgate]

In the past year, I have seen the light with index funds and exchange traded funds that follow indexes. After doing the research, I realized how much of my money is actually being taken from actively managed mutual funds. It made me mad at my previous job that their 401k did not offer ANY index funds, just American, Calamos, Davis, and others with a 5.75% front load fee! Your investment has to start making 6% just to recoup what they initially take. Thanks for continuing to remind us that the financial service industry loves fees, and no one realizes how much they actually pay when it comes to actively managed mutual funds.

[Brian S.]

If I am ever asked to give a graduation speech, which seems awfully unlikely, my advice will be to invest in index funds early and often.

[Matt Jabs]

Great info FMF, luckily I do not require further convincing. I'm not sure why someone would put the energy into arguing these points...but to each his own I suppose.

Thanks for passing all your index fund knowledge & experience on to everyone else. It has been very beneficial to me.

[Bill]

This is a tough one...index funds are managed...someone has to pick the members of the class being represented and studies have shown that this selection has some weight.

The concern I have has to do with the 10% growth that everyone loves. It doesn't make sense...our economy does not grow at 10% y/y on average so how do we get that kind of stock growth? The answer is that we really don't over some fairly long periods of time and if you guessed wrong (like last year) you won't see 10% y/y growth (on average of course) for a long time. 10% per year implies doubling in size every 7.2 years...who thinks that our economy (the average or index matches this right?) will double in 7 years? To think that it will even come close just ignores logic and math. Small economies and markets can easily double, but U.S. Industrial production (Dow or S&P 500) cannot in any nearby time frame.

Now, Do I think I can time or beat the market? I wish. and I agree that Wall Street Coneheads can't either, so why pay them. If I had a solution, I'd be rich (or richer). Thinking that indexing is a panacea is just as foolish as paying Wall Street, but at least it is a cheaper option. My thesis here is that indexing is certainly the easy way (and cheaper), but do not expect returns like we have seen for the last 20 years in the next 20.

[Rick]

I agree that index funds can be semi-actively managed. For instance, say the S&P 500 drops one stock and replaces it with another one. The way various index funds accomodate this change can cause their returns to differ by several basis points. Not that this affects your argument for index funds in any way; however it is something to note.

That said, I still believe that if you are willing to invest time and energy into the stock market, you *CAN* beat the average. However, the size of your assets definitely affects this. For instance, I, with my $25,000 in assets, can find good investment opportunities. I can day-trade. I can buy and sell options. As a result, my results can be dramatically higher than the average. However, the Vanguard 500, with $73 billion in assets, has much less flexibility. A fund manager with that much money could not make a 50% return by investing in a particular opportunity, since that is just too much money to throw around.

This is the same reason why Berkshire Hathaway made huge returns in its early years and decades, but as the company grows, there just aren't as many opportunities to make the huge returns. As a result, total returns have dwindled over the years.

Also, fund managers are limited by various SEC rules, fund rules, etc. For instance, sometimes mutual funds are not allowed to short stocks. Sometimes they are not allowed to buy options. Sometimes they are limited by the fund's propectus to only investing in certain asset classes. Mutual fund managers usually cannot day trade stocks, since that would cause the market to fluctuate too wildly.

A normal retail investor has no such limitations, and can thus make higher returns.

A retail investor can often make 25% or more gains in a year. A mutual fund manager usually can not make such gains, unless the stock market as a whole happens to see these kinds of gains.

[Rick]

To be clear, you have to want to play an active role. If you have no time or no interest to do your research every day in the market, certainly index funds are the way to go. But if you want to invest time and energy into the market, I do believe you as a normal retail investor can beat the market average.

[Early Retirement Extreme]

What Rick said. The larger you are, that is, the larger, the closer to average your returns are going to be by construction. Naturally the index will beat the average of all actively managed funds since that average IS the index, but charges a higher fee.

However, choosing the index only makes sense if you think performance is random or you have absolutely no idea how to spot performance.

Consider a small cap company with tradable options. The outstanding volume might be 1000. If they're valued at 0.30, then $30000 can buy the entire position. A retail investor individual can dominate this position if he so chooses. Someone managing $10b can not touch it. We do not even need to consider options. Consider a company with a daily volume of 1000 shares. Suppose it trades at $15. Again this means that entering and exiting positions will take a long long time. Big funds can not go there. It is a market inefficiency! Let's make that very clear. Small fry like individual investors can make money there because large funds simply can not enter. Hence, it doesn't really matter that big fun managers are really bright and spend all day, when they can't play the same game. Yes, individuals are probably not going to beat them on large caps that are followed by 25 analysts, but they have a competitive advantage for companies that are only followed by 1 or none at all.

Now for the case for the mutual funds. It is relatively easy to find funds where the average tenure of the managers is 15+ years. Funds that are named after their managers (so they don't just get replaced if they underperform like a bunch of hotshot 25 y/o's). Yes, indeed there are tons of Wall Street shenanigans; I would say particularly with large companies that manages tens or hundreds of funds. There are also small companies and then of course there are the companies that Main Street never hears about with anonymous looking pages that requires passwords and are by invitation only. But back to the small companies. Fund companies like Oakmark, Longleaf, FPA, Fairholme, Dodge & Cox, Hussman, ... where the managers have their most of their own net worth riding on their performance rather than the 75% other funds where the manager gets fired if he doesn't beat the index and doesn't take changes because he want's a safe upper middle class career. The point I'm trying to make here is that while all indexes are more or less similar in their construction, fund management differs between funds. It is not that difficult to find the good managers. Go to their websites. Read their annual reports a few years back, see if they make sense. You can see who probably got A+'s and who got C's and still managed to become manager somewhere. Don't go by stars and percentages. Those usually take care of themselves. Pick the manager.

[Old Limey]

A large factor that no one has yet mentioned in this connection is that in the last 16-17 years the playing field for investors has been made level by the introduction and rapid development of the Internet.
At the beginning of the nineties if you signed up for a proprietary database of mutual funds that was updated by modem every day and came with great charting and analysis software you could be way ahead of most investors and could easily ouperform the market. Another factor was that at this time trading volume was a fraction of what it is today and the degree of active public participation in trading was far smaller. This also lead to the actively managed, no-load, funds that I used in those days to also be much smaller thereby enabling their managers to be very nimble in changing their fund allocations. Today these funds have become multi-billion behemoths that turn like a gigantic aircraft carrier and not like a little PT boat.