I am a proponent of passive investing.
That means investing in passively managed index funds that track a specific market sector. Primarily, exchange traded (ETF) or open ended mutual index funds.
Research indicates that actively managed portfolios tend not to perform better than passive portfolios. And actively run portfolios cost investors more money in fees and expenses than passive.
So why take an active approach?
Most investors probably should not.
The Wall Street Journal offers up a nice article providing further support for a passive investing strategy.
Active Funds Cost Investors More Money in Fees
Actively managed funds are significantly more expensive than passive. And the fees have not declined over the years.
“Stock funds charged an average expense ratio of 1.41% in 2010, down only 0.03 percentage point from 1997, according to investment-research firm Morningstar. Actively managed stock funds charged an average 1.45% in 2010, while index mutual funds charged a much-lower 0.73%. ETFs were the cheapest, with average fees of only 0.6%.”
While this may not seem like much to you, over time the compound return impact is enough to take notice.
For example, on average one can save 1.39% annually by investing in an ETF over an actively managed fund. Given a portfolio of USD 100,000, that translates into additional portfolio growth of USD 14,802 after 10 years. After 20 years, USD 31,796. After 40 years, USD 73, 702.
Not a bad incremental return, based simply on the type of investment you made.
Additionally, in today’s volatile global markets, an additional 1.39% return may be the difference between showing a profit or a loss in your portfolio in any given year.
Look back in your local markets over the last 10 years. There are likely some down years. An extra 1.39% might have looked pretty good.
Why Do Investors Happily Pay High Fees?
Investors often think that active management must be able to outperform a passive approach.
“Investors are tolerating higher fees in part because many are convinced that stocks will once again deliver the fat returns of the 1980s and 1990s, and that fees aren’t as important as manager performance. Many investors still look first to funds’ past results when deciding what to buy, says Todd Rosenbluth, a mutual-fund analyst with S&P Capital IQ.”
Unfortunately for investors, this is not a wise strategy.
As fund prospectuses like to say, past performance is no guarantee of future results. Again, just look at your local (or global) markets over the last 10 or 20 years. There have been many ups and downs.
Active Management is No Guarantee of Better Performance
Research is quite mixed as to whether active management can outperform passive on a consistent, long-term basis.
Professionally managed investment portfolios are subject to fund management turnover and human error in choosing the optimal investments.When choosing an actively managed fund or portfolio, you need to look at the quality of staff managing the portfolio today.
Even fund managers and investment analysts that have been in one place for many years may fluctuate in their relative skills from year to year. Finding the absolute “best” professional may not be easy, if even possible.
Or perhaps in seeking stronger relative returns to their peers, the professional alters the management strategy for the portfolio. That may cause you to end up with a different investment profile than you desired (e.g., more risk, growth instead of value, seeking capital instead of dividends, small cap instead of large, etc.). Always make sure that the stated investment plan for the portfolio reflects reality. Be on guard for potential problems including window dressing and style drift.
And when assessing professional managers, make sure you compare apples to apples.
At times, unforeseen external variables (e.g., natural disaster, political coup, environmental issues, etc.) can quickly turn a wise investment sour. As well, other factors may negatively impact a well managed portfolio, so that consistently beating the market benchmark is a difficult proposition.
So there are many reasons why active management has a difficult time beating the market.
But if you should not rely on past performance and fund management as the best ways to assess future returns, what should you do?
Look to Costs as a Better Predictor of Fund Performance
The cost structure of the fund or portfolio may be the best predictor of future results.
“Researchers have found that expense ratios are one of the best predictors of fund performance. The cheapest quintile of U.S. stock funds were more than twice as likely as the most expensive quintile to survive and beat their categories’ average returns from 2006 to 2010, according to Morningstar.”
This echoes the Vanguard research I wrote about earlier.
It also makes sense in light of the impact of investment costs on compound returns. The returns that really drive your cumulative investment growth over time.
Do not look solely at management fees when assessing active managers’ performance. Review the other costs as well. Active management is active. That means more trading (and higher related costs) than in a passive portfolio.
“Prof. Evans’s research has found that actively managed mutual funds rack up an average of 1.44% in trading costs annually, which comes straight out of returns—on top of their posted expense ratios. The worst quartile of funds loses almost 3.5% annually in trade costs.”
As you can see, these trading costs can add up for investors.
For many individuals that I deal with, this is a very difficult concept to accept.
It is very hard for people to believe that a professional asset manager cannot beat the markets on a consistent, long-term basis. Investors typically believe that by paying more for professional management, they will achieve better performance.
But, as the article states:
“When you pay more for a car, you expect a better car,” says Russel Kinnel, Morningstar’s director of fund research. “It doesn’t always work that way with funds.”
There is no positive correlation between higher fees and higher performance for general actively managed funds.
Unless you are planning to invest in a niche or inefficient market, I suggest you focus on a passive approach in your investing.
Stick with low cost index funds. Keep as much money in your pockets as is possible. Then let it compound on your behalf. Not your money manager’s.