Why Actively Managed Funds are Doomed to Fail

Actively managed funds are the dominant type of fund in the industry. As an example; Asset management titan Blackrock has $4 trillion assets under management. Of this value, approximately $600 billion is in iShares products, which are passively, rather than actively managed. This leaves a whopping $3,400 billion in actively managed investments.

With such widespread support, it must follow that actively managed funds have been proven time and time again to beat their boring cousins – the passively managed funds that don’t carry out stock market research or attempt to ‘stock pick?

Wrong. As shown by this white paper by Portfolio Solutions and Betterment.

The following logic explains the fundemental flaw at the heart of actively managed strategies and explains why passive funds are on the rise:

  1. All active managers aim to achieve a superior return compared to the average.
  2. Fund managers (including pension funds and insurance companies) dominate the stock market by % of holdings.
  3. Therefore the average return of actively managed funds (before fees) will be very similar to the average return of the market. (The funds are the market)
  4. Therefore after management fees (1% – 2%), the average return from an active fund will be on average less than the market average.

It may seem counter-intuitive to expect to be worse off with experts than the ‘invest in everything’ approach of an index fund. Perhaps this illustration using the example of an antique auction house may help explain how this paradox occurs:

An Illustration: The Auction House.

Bargain hunt is a well known daytime TV show in which amateurs and experts battle against each other to find valuable antiques at cheap markets to sell on at a profit at auction. An example would be an expert buying an antique lamp for £20 from an unwitting individual trying to clear their loft in a car boot sale. The expert could then take the lamp for auction – find a selling price of £100, pay £10 of fees to the auctioneer and walk away with a healthy £70 profit. What is clear is that in a world of imperfect information, a savvy and experienced bargain hunter can find treasures going cheap, and profit from this pricing difference. When experts and amateurs compete, experts will profit.

In such a scenario, a good idea for amateurs would be to team up with an expert – the amateur can provide the cash, the expert brings their knowlege and profits could be split. This is a fair reflection of the pact that investors implicitly make with fund managers in a very uncompetitive stock market – where the vast majority of other participants are amateurs.

Except this is not really the case. As stated above – the stock market is packed full of sophisticated investors – Pension funds, Hedge Funds, Mutual funds of all shapes and sizes, not to mention professional speculators or private investors with relatively high levels of experience.

In the antiques scenario. What would happen if everyone was an expert? The car boot owner would have known the lamps true value, and would not have parted with it for less than its value – £100. If this was bought at this price, and then sold at auction. No profit would have been made. All obvious ‘easy wins’ have instantly disappeared and the expert is now useless.

It gets worse – if the expert continued with their trade, they would be disappointed to realise that when selling the item at the auction house – the fees charged by the auctioneer means a £10 loss is made instead. In such a market – amateur antique buyers are better off not trying to buy and sell for quick profits, but rather buy any antiques at the fair – knowing that the price they pay reflects their fair value.

To bring us back into stock markets – the auctioneer fee can be compared to the management fee that active managers charge. Therefore not only does the management team have no discernable edge on the other market participants, but they will charge you a premium either way – meaning you would have been better off just avoiding active management completely and buying shares yourself.

The Alternative: Low Cost, Index Trackers

Rather than settling for below-average returns, we can obtain very close to that market average by investing in a low-cost, passive fund. Buy investing in all the constituent companies; these replicate the indices such as the FTSE100 or S&P500 rather than trying to beat them. These funds are very efficient to run, and these savings are passed to the investor in the form of lower annual charges. The difference can be staggering. Whilst the (active) Schroder Core UK Equity Fund charges 1.42% per year in management fees, the (passive) iShares S&P500 tracker charges only 0.07% per year.

Don’t just take my word for it. In his latest letter to shareholders, legendary investors Warren Buffet comments: “The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal”

 

 

Simon OatesWhy Actively Managed Funds are Doomed to Fail

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