Active Investment Managers Just Can’t Win
If you’ve spent any time on this site, you know what a big fan I am of index investing. It just seems silly to me to do anything else when it’s so easy to do incredibly well with the simplest of strategies. Add to that the fact that professional investment managers often don’t have your best interest at heart, and even when they do they still can’t beat a simple index, and really what more evidence do you need?
Well, in case you need a little more convincing I’ve decided to pass along this eye-opening infographic from Business Profiles demonstrating just how poorly all kinds of active investment managers have performed in recent history. Now, to be totally fair, looking at a single time-frame (which this does) is no way to make definitive conclusions. But unfortunately for active investment managers, this story is just more of the same. Now matter how you spin it, they just can’t win.
While I actually agree that for the average person indexing makes more sense, there are a couple of really odd stats in this infographic. Bill Miller apparently beat the market in 15 years and then lagged it for 10. So over 25 years he beat the market 60% of the time. Likewise Warren Buffet lagged the market in 3 out of 10 years. Or in other words, he beat the market 70% of the time. Maybe they could have picked some better “legends” to take cheap pot shots at? Also why highlight that Bill Miller lost 54% between 2006 and 2008? DJIA also lost 54% between 2007 and 2009. Talk about selective memory! 🙂
Do very much agree regarding hedge/pe/vc funds. These make little or no sense other than to the managers and maybe in niche asset classes (i.e. not bonds or equities)
I definitely agree that Warren Buffett is a bad example. But Bill Miller is actually a really good one. He’s a classic example of someone who had a long run of out-performance, got a ton of attention for it, followed by a long run of under-performance. It’s an important reminder that a manager’s past performance is not a good guide for how he/she will do going forward. Choosing a fund because it had strong returns in the past is not a likely path to success.
There are several reasons why people go with active funds than index funds even when it may not be in their best long-term interest.
First, are the upfront fees. My IRA is with eTrade. They have thousands of no load, no transaction fee mutual funds, but not a single one is an index fund. So I can get an active fund for free (other than the purchase price, of course), but have to pay anywhere from $10-$35 to buy an index fund. When I’m investing $100 at a time, that’s a pretty big bite. Are index funds going to beat the active funds in my portfolio by 10-35%?
Second, it also goes against pretty much every piece of investment advice out there. Not in reality, maybe, but certainly in perception.The very first thing anybody ever says or reads about investing is the importance of diversification. Investment calculators give you a breakdown of what asset classes to invest in and what percentage to do so based on your risk tolerance and age. But while there are some index funds out there just for certain types of stocks or bonds, when people think index funds, they think of investing in the entire stock market. Yes, that is diverse as a whole, but it goes up and down as a whole as well whereas the whole point of diversifying your portfolio is that when some stocks go down, others may be going up.
I’m sorry but your logic here is flawed on both counts.
On the first point, there’s nothing requiring you to keep your IRA with eTrade. If you wanted access to top-notch index funds at almost no cost you could easily roll it over to someone like Vanguard. Every transaction that purchased a Vanguard fund would cost you nothing. If you don’t like that route, there are other brokers out there offering good funds for a much smaller cost that you mention here as well (Schwab is one). So your options are much less limited than how they’re presented.
On the second point, I’m not totally sure what your argument actually is. A total stock market fund is as diversified as you can possibly get within the stock market. You will own the stocks going up as well as those going down. That is diversification. If you’re more of the slice-and-dice type and want to break it out with small/large, growth/value and the like (not my thing, but plenty of smart people advocate this strategy), there are plenty of index funds that can help you do that as well. If anything, actively managed funds get criticized, and rightly so, for doing nothing more than providing the diversification of an index fund at a higher cost. The value of active management would really come in the form of an undiversified fund where you hoped the manager was correctly picking the few stocks that would outperform. If you want real diversification, a good index fund is easily the most efficient way to get it.
The problem is the difference between perception and reality. Both what you said and what I said are true. I’m simply staying how many people view the situation.
So is your argument that people may have an incorrect perception either because they don’t fully understand their options or they are misled by poor advice? If so, then I agree. And it’s up to those of us who know better to help spread the word.
By the way, I took a quick look at eTrade and I see plenty of index funds that you can purchase without any fees. Here are a few examples that track the S&P 500: NOSIX, SVSPX, BSPSX. They do have minimums, though the first two look to be only $500 within an IRA.
I agree to that. Your past couple posts on the topic have seemed to be to have tended towards incredulity over why anyone would act that way, and I was providing an explanation for that. I think that it’s easier to convince somebody when you know why they hold a certain thought process in the first place.
Thanks for that info. When I last looked into index funds a year ago, they didn’t have any no-fee options.
Fair point. I don’t meant to direct that sentiment at the consumers, though I can see why it might come across that way. If that’s the case then I’m clearly doing something wrong. My alarm is more with people who advocate for the sub-par approaches than with the people who don’t know any different.
A good illustration of the fact that humans are fallible and beating the market isnt easy.
I’ve always been a fan of diversifying into different sectors – keeping in mind the cyclical nature of markets.
Emerging markets which manufacture and export significant amounts are far more likely to experience above average growth than old, bloated, debt ridden western economies.
Again smaller companies funds tend to out perform the big solid blue chips in the long term (over 5 years).
The problem I have with index trackers is that they buy the crap as well as the good – there is always a good case for actively managed funds. There are managers out there who have consistently beaten the market over 5, 10 and 15 years +
Seek them out and reap the reward of their knowledge.
A good example for you sceptics would be AAS.L (a london ticker symbol)
“The problem I have with index trackers is that they buy the crap as well as the good”. This is a classic line, but it has the implicit assumption that you can have consistent success differentiating between the two. Unfortunately the evidence simply doesn’t bear that out. If you would like to argue otherwise, I would ask you to offer some real, scientific research demonstrating a persistent ability to pick winning investments. I have not seen any.
As for the specific example you give, there will always be managers who DO manage to outperform the market as a whole, even over long periods of time. Some will have genuine skill, and some will just be lucky. But it will happen and I would never argue otherwise. But this still leaves us with the reality that to take advantage of this you would have to do one of two things:
1. Find the manager who consistently outperforms period after period, or
2. Consistently jump from manager to manager just as the last one starts to falter and the next one starts to succeed.
Unfortunately, all of the real research we have shows that the probability of either of these happening is extremely low. Is it possible? Sure. Is it likely? Not at all. I prefer to give people advice that is likely to succeed rather than advise them to gamble their investments on the hope of getting lucky.
Nice infographic Matt! I definitely prefer index funds for the lower fees and especially the fact that they are less of a hassle.
I’m with you Nick. Better performance with less effort. What’s not to like?
That’s a slick infographic. The next time someone asks me why we’re passive investors, I’m just pointing them here.
It’s a pretty powerful visual.
I think using a managed fund vs. index funds is a little like gambling! Depending on your timing, you could have 15 good years or just catch the bad years. Over the long run, index funds is the best way to get a low cost return.
I couldn’t agree more.
I love infographics and it makes a good point and provides a good
visual to help with the explanation. Of course, they are a little
simplistic, but still cool. Thanks for continuing to spread the word about index funds. You know I’m with you on this. I think a lot of people think like Mike “Seek them out and reap the reward of their knowledge” regarding good fund managers. But it is so hard for a manager to be consistently right. That and how do you find the best fund manager? Based on past performance? And one significant factor are costs…even if actively managed funds outperform…when you take into account the fees/expenses…you might have been better off with the index fund.
You’re spot on there Andrew. It’s just so unlikely to find a manager who will beat the index over any period, and even more so one who will continue to do so over many periods. And while the performance is highly variable, the costs are guaranteed. It just isn’t worth it.
If you ever come across a similar info-graphic looking at mutual fund performance vs. equities, please post that. I couldn’t agree with the general point more, but for most investors the choice isn’t between hedge funds / vc and S&P, it’s between mutual funds and the index. Great post.
Hi Herbert. I’ve written on that topic before, notable here http://momanddadmoney.com/how-to-beat-80-percent-of-investors-with-1-percent-of-the-effort/ and here http://momanddadmoney.com/the-experts-cant-pick-stocks-can-you/.
Matt, thanks for those links. I see that you are citing S&P’s research – they do great papers on relative performance.
What I am actually interested in is average mutual fund performance. If 3/4 mutual funds underperform, but the 3 losers only underperform by 1% while the one winner outperforms by 10%, your expected value is higher to pick a basket of mutual funds. IMO this is where the S&P research could be a little bit better. It could be more powerful to find what the average US large cap equity mutual fund performed, not whether on a binary level most underperformed or outperformed.
If I’m understanding you correctly, then this is something that Rick Ferri has actually already looked into, and is part of one of the articles I referenced. Not only do most mutual funds underperform, but the level of underperformance is greater than the overperformance from the other funds. In other words, your odds of winning are not only low, but the amount you might win by is lower than the amount you will likely lose by. It’s not an incredibly promising situation.
Not to get too deep in the weeds here, but Rick is using median numbers. To quote him:
“Measuring the median underperformance and outperformance of the actively managed fund portfolios was an important part of our analysis. Even though most active fund portfolios fell short of the index fund portfolio, it still might be worth investing in actively managed funds if the winning portfolios had beaten the index fund portfolios by a significant amount. In theory, large outperformance by winning portfolios could make up for their low probability of success.
This did not happen in Scenario 1 or in any scenario that we tested. The 17.1% of actively managed fund portfolios that beat the index fund portfolio outperformed by 0.52% annually using the median or middle portfolio return. This additional performance was far too low to make up for the median -1.25% annual shortfall from the 82.9% that did not beat the index fund portfolio.”
Median is a good indicator, but to truly get at this, you need the mean. As the first paragraph points out, if you have one huge winner and a bunch of small losers, active management wins. Median is the wrong measure here, because the median could be a poor indicator of the winners (and losers). Consider if the winning outperformance was 1%, 1%, 10% – the median would be 1%, but your expected outperformance would be 4%.
I completely agree with your view on active vs. passive as well as Rick Ferri’s – my only point is that putting some more concrete numbers around it can make a much stronger case.
I see what you’re getting at, but I’m not sure it makes much of a difference. In your simple example, the mean only matters if I can either correctly pick the outlier ahead of time OR pick all the outperforming funds and therefore get the mean return. Since in the real world there are thousands of funds to choose from AND we know that people can’t pick the right funds, neither of those seem realistic.
Your example is also only showing outperforming funds and assumes a 4% based on being able to pick only from those three. That’s not how it works in the real world, as you have the entire universe of funds to choose from, including the ones that will underperform. And we already know the expected return of that entire universe and it’s negative.
With such a large universe of funds, the mean will only be significantly different from the median if there are a small cluster of huge outliers. And again, for that to be meaningful there would have to be some level of persistence that would indicate that you could pick those outliers ahead of time. Otherwise you’re still looking at the probability of failure, as told by the overall figures showing active funds losing.
What I think would be interesting would be for SPIVA to measure things in tighter percentiles. For example, is there any persistence among the top 5% of performers? I doubt it’s the case, but if there’s data on that I haven’t seen it.