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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. In the last 10 years many prominent investors including Warren Buffet, Jack Bogle and Ray Dalio have warned about this. We’re simply echoing their message here to ensure our readers hear it.

In short, actively managed mutual funds are almost never a good deal. These funds include fees that, among other things, pay the salary of the fund manager. If the fund outperforms the market (plus the additional fees charged) then this would be OK. However, this is almost never the case! A study by industry expert Robert Arnott (the founder of Research Affiliates) found that 96% of mutual funds perform below the market average!

Warren Buffet, Ray Dalio and Jack Bogle (three of the highest profile investors in the world) recommend (passive) index funds over active funds. Warren Buffet has even stated that, upon his death, he’d instruct his wife to invest as much as 90% of his wealth in low cost index funds. 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 fraction of an actively managed fund. 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. Many companies create a whole slew of funds. In any given year (or span of a few years), a small percentage (evidently about 4%) of these will perform better than the market. In subsequent years, the company will advertise those funds as evidence of their past success (while sweeping most of their funds under the rug). This is akin to gamblers that claim financial success because they gained money on one particular slot, despite the overall failure in the casino. Funds that were successful one year are still about 96% likely to fail (perform below the market) the next year; just like the gambler that returns to the casino to capitalize on that lucky slot!

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