A longtime reader asked me the other day, “how do you convince someone that actively managed funds are worse than passive?” I think it’s a good question, not because it’s possible to convince someone that actively managed funds are worse than passive funds (it’s not possible to convince people of anything, in my experience), but because answering the question highlights one of the most important relationships in investing: the relationship between cost and confidence.
All active investors get the market’s return
When you buy a mutual fund or exchange-traded fund linked to a market-capitalization-weighted index, you’ve decided to “settle” for the market’s return. Your investment will rise and fall along with the index, since the fund’s holdings are linked to the market capitalization of the index’s components.
If all passive investors get the market return, then by definition all active investors also get the market return, minus trading costs, since active investors are trading against each other: each active investor’s winning bet is another active investor’s losing bet, minus trading costs on each side.
Good active management is cheap at any price
If you knew your active fund manager was going to beat the market indices by as little as 1% per year, after taxes and fees, you should be willing to pay virtually any amount for their services. Over long enough time horizons, even modestly higher investment returns result in enormous increases in the final value of an investment.
I know of no way to identify good active management in advance
After the fact, all the people who selected “good” active managers will end up much richer than all the people who selected “bad” active managers. But as an investor, your task is not to identify who outperformed in the previous 10, 20, or 30 years, which you can easily look up online, but who will outperform in the next 10, 20, or 30 years.
As if that weren’t unfair enough, over the course of their careers active managers move from fund to fund, and eventually leave the business, one way or the other, so the benefits of correctly identifying the best active manager have a built in time limit, whether it’s retirement or the grave.
How many times do you have to be right?
Passive, market-capitalization-weighted index funds don’t absolve you of the responsibility, or consequences, of investing your money well. If you invest in Vanguard’s Total Stock Market Index Fund instead of the Vanguard Total International Stock Index Fund, and the latter outperforms the former, then you made the wrong choice and performed worse than someone who made the opposite choice.
But when you pay an active mutual fund manager to decide, over and over again, which stocks to buy and which to sell, you’re not just counting on that person to be a better stock picker than you are. You’re counting on that person to be enough better a stock picker than you are to make up for the management fees you have to pay them whether or not they outperform.
When you know, by definition, that all investors in actively managed funds will underperform all investors in passively indexed funds, due to the higher fees charged by actively managed funds, the core question becomes clear: no matter how good you are at picking active managers, how many times do you have to be right to make up for all the fees you have to pay whether you’re right or wrong?
When you’re wrong, you pay higher management fees and underperform. When you’re right, you pay higher management fees and outperform. How sure are you that your excess returns will exceed your excess losses? It appears to me that there is no evidence whatsoever that individual investors have any capacity to select skilled active managers even once, let alone over and over again throughout an investing lifetime.
So I choose to invest in passive funds, because I think the amount I save in management fees is greater than the amount I could realistically squeeze out of a lifetime of hopping from one expensive actively managed fund to another.
But if a Wall Street Journal from 2048 fell into my lap, I’d happily change my mind!
I completely agree but there are a few things to consider:
1) The stock market is after all a market, so if most people invest in index funds the stocks composing that index will be more dear based on more demand. Stocks outside an index will be more depressed and cheaper which might decrease the margin of error for active fund managers making it easier to profit (e.g. by buying all potential index candidates and profiting mightily from the inclusion of one) We are not there yet so no need to worry about.
2) If a market is inefficient or requires special knowledge (e.g. African frontier markets, some bond markets, some commodity, any arbitrage) I can see going with an active manager but most retail investors shouldn’t be doing that anyway and if, only with a tiny sliver of their portfolio — I am for instance intrigued by merger arbitrage but the amount of my portfolio I would risk hasn’t passed the minimum investment threshold of such a fund…
xgerman,
Your second point begs the question: once you have identified commodities, merger arbitrage, or frontier markets as areas where an active manager can earn excess returns, you still have to pick an active manager, and that active manager will be trading against other active managers who agree there are excess returns to be had, but disagree with your active manager about which side of the trade to be on.
So as I said in the post, if you know your active managers are able to earn excess returns, you should be willing to pay them almost any amount for their services. But I have no idea how to identify winning active managers in advance.
—Indy
Umm, no.
Active investors don’t get the market return. They get a slice of the market return given the stocks they hold. That slice may have more or less of the total market return, given their holdings.
As you say, it’s impossible to know which active managers will outperform the market ahead of time. Actually, I disagree there as well. It’s a matter of the time scale involved. No active manager will outperform the market market long term. The mutual fund industry however, relies on the fact that a few managers will get lucky over the a term of 1 to 3 years.
El Ingeniero,
I apologize for the confusion, I said *all* active investors get the market’s return, not that *every* active investor gets the market’s return. The winning investors win and the losing investors lose. But since all active investors are trading against each other, each trader’s win is another trader’s loss, and as a group they’ll receive the market’s return minus trading costs, management fees, and taxes.
—Indy