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Active funds: for the buyer or the creator?

2017-12-24, Michael Thompson

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Active funds: for the buyer or the creator?

The purpose of this article is to warn readers about actively managed funds. You may have heard a lot of this before, many big-name investors like Warren Buffet, Jack Bogle, and Ray Dalio have discussed this. We’re echoing their message here to ensure our readers hear it.

In short, actively managed funds are almost never a good deal. They include fees that, among other things, pay large salaries to fund managers. If the fund outperforms the market plus the additional fees charged then this would be OK. However, this is almost never the case! Numerous studies have all come to the same conclusion—roughly 95% of active fund managers underperform the market.

If you think carefully, you’ll realize that it has to be this way! If the market returns 20% in a period, the passive investors in that market earn 20% by definition. The remaining investors (the active ones) must also earn 20% collectively. The only difference is that active investors pay more taxes and fees, and hence they earn a smaller net return.

Another reason why most active investors fail is the so-called skewness of returns. When the market returns 20%, most stocks earn much less than 20%. What typically happens is a very small number of stocks have high returns, while the majority have subpar returns. If you (or a manager) pick individual stocks, you’re unlikely to capture the high performers.

For these reasons the likes of Warren Buffet, Ray Dalio, and Jack Bogle recommend passive index funds for most individuals. Warren Buffet has even stated that, upon his death, he’d instruct his wife to invest as much as 90% of his wealth in a low-cost S&P 500 index fund. An index fund spreads your money over a market (e.g. the S&P 500) with a simple formula. The fund manager is not trying to pick winners, and fees are typically a small fraction of actively managed funds. There is still some variance in the fees charged, so check the expense ratio.

Warning. Here’s something to watch out for if you’re still tempted to buy active funds. Companies sometimes create a whole slew of funds. A small percentage of these will outperform the market over a few years. In subsequent years, the company will advertise those funds as evidence of past success (while sweeping most of their funds under the rug). This is akin to gamblers that claim success because they gained money on one particular slot, despite overall failure in the casino. The "successful funds" are no more likely than others to succeed next year, just as there's no reason to think the "lucky slot" will be lucky tomorrow!

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