Are Actively Managed Funds a Fool’s Game Compared to Index Funds?

When it comes to investing in stocks, some of us like to be highly active stock pickers. Others among us like to invest passively, even to the point of a “set it and forget it” strategy.

One example of active vs passive can actually be indirect, through mutual funds.  In this example, as many of us know, we aren’t exactly picking the investments in a fund. Rather, the fund manager is picking the investments. Sometimes, these funds can actively trade many stocks. So even though we buy into mutual funds at a price per share (based on the net asset value) similarly to how we do a stock, there can be tons of trades going on with our money even if we ourselves don’t sell anything. The fund manager is behind the scenes making the moves, making this an active strategy of sorts.

On the other hand, if we buy a mutual fund that’s simply index-based, there’s very little activity involved. An S&P 500 index fund, for example, is set up to mirror the performance of the actual index. The brain work is taken out of the process, and there isn’t a fund manager’s acumen influencing the performance of the fund. It’s all based on how the individual stocks in the fund perform.

This of course brings us to the established, oft-discussed topic of index funds vs. actively managed funds. Thinking about it based on what we’ve discussed above, we’re really choosing between:

  • Professional fund manager input into our investment; or
  • No professional input, just independent stock performance guiding our investment

On the surface, it just seems logical that all things being equal, a professionally managed fund should outperform one that’s not professional managed, right? We’re often told about the virtues of index funds, and passive investing, but shouldn’t there be value to having a professional guide the stock picking within a fund?

Well, maybe there isn’t always value to a a professional actively managing a fund.

An article I saw on Moneywatch further supports the case for index funds over actively managed funds. According to this article, data from Standard & Poors shows that active fund managers have been consistently outperformed by index-based benchmarks. This finding is across cap size and covers the last 3 years.

Here’s the extent of the disparity with these actively managed funds:

  • Large-Cap focus: 64% were outperformed by the S&P 500
  • Mid-Cap focus: 75.1% were outperformed by the S&P MidCap 400
  • Small-Cal focus: 63.1% were outperformed by the S&P SmallCap 600

Thus, for all the extra fees that are being paid, investors are getting nothing back. In fact, one could say that investors are getting punished for going with actively managed funds!

Now, there are some funds that clearly do outperform the market. However, the majority haven’t been doing so.

Personally, I’ve been a fan of index funds, but have a mix of index and actively managed funds.  At this point, it’s hitting home that maybe I should jettison the actively managed funds and replace them by adding additional investment in index funds?

I suspect that many people (including me, apparently), have previously found index fund investing to be “average” or lacking risk taking or a pursuit of wealth.  Who wants to be average, right?

Well, maybe average actually means winning in this case!

My Questions for You:

If you own mutual funds, do you focus on index funds?

What do you think about the notion that the pursuit of average, in terms of market returns, is actually a winning strategy in some ways?

Why do you think people pursue actively manage funds, despite the evidence that index funds outperform them?

 

Comments

  1. says

    The problem with actively managed funds is that you are at the whim of your fund manager. Fund managers change and this will reflect on the returns.

    With indexing a crucial element that could be detrimental to investing, emotion, is taken out of the picture. That’s why indexing (& disciplined rebalancing) wins, long-term.

    • Squirrelers says

      MoneyCone – yes, that’s very true about emotion being taken out of the picture. Also, good point about fund managers changing. When you put it all together, the reality is that “doing nothing” with index funds beats putting money in actively managed funds most of the time. Not always, but more often than not.

      • says

        technically, “doing nothing” beats actively managed funds more than 50% of the time

        without the fees and some of the managers making systematic human mistakes it would be almost exactly 50% of the time… the problem is you don’t know which 50%!

      • says

        And index funds aren’t really doing nothing. You are doing something — you’re tracking what investors in aggregate are doing, rather than 1 investor or group of investors in particular. You’re also paying less fees by doing so.

        • Squirrelers says

          Yeah, the “doing nothing” part of index funds really means taking a more passive vs. active approach. We’re always doing something, it’s just how active we are that’s of note. It reminds me of how some people say that they avoid office politics, and like to keep quiet because they “aren’t political”. Well, the silence is a political choice in it’s own right!

    • Squirrelers says

      krantcents – people often ignore statistics. Hubris and greed may be a part of it? Or, perhaps just a genuine desire to achieve results better than average.

  2. says

    1. Just index
    2. empirically true
    3. My FIL, an accountant, was sweet-talked by the Edward Jones guy into buying a high fee fund. He was asking us for advice on individual stock picks, so we sent him the Bogleheads guide… and he fired Edward Jones. So in his case, it was lack of knowledge. Cheap index funds haven’t always been easily accessible and back in the day, mutual funds were a great benefit over individual stocks (they probably still are for small investors, even with the fees). But times have changed.

    • Squirrelers says

      Nicole – back in the day index funds weren’t easily accessible. Trades were not as easy as they currently are, in general. Times have certainly changed, and in this day and age we have much more information, speed, and options.

  3. says

    I believe that actively managed funds are good for the manager. Clearly, it’s possible to beat the index if you:

    * have privileged information (insider trading laws don’t remove privileged information; they just make it possible for some people to benefit if they’re on the right side and being liked by the govt doesn’t hurt either. Look at the stock market returns of senators and congresspeople)

    * Are lucky.

    * Simply better and more skilled at integrating the information that’s available.

    I don’t think there’s anything wrong with applying skill to privileged information per se — maybe you were one of the only ones that believed that gold was undervalued when it was at $300. Your belief was privileged information in a sense, perhaps based on some solid facts that not everyone was aware of but you dug up with a bit of research, but it went against conventional wisdom at the time.

    What is wrong is when we’re forced to cover the bad bets of certain ‘investors’ via the public purse, but that’s something else.

    Aside from that, pure statistical luck also plays its part.

    What I wonder is how far the passive index game can go. We need some active investors to drive the market, because otherwise what do you track? But… maybe it’s more optimal if most people are in index funds and the best investors drive the market through their own investing? Do we really need a zillion actively-managed funds? Probably not.

    • Squirrelers says

      Yes, the actively managed funds are good for the manager (and firm). Agreed!

      I know we do need those active investors in the market. They’re always going to be there, in the bigger picture I suspect that it’s human nature for many of us to try to achieve, try to get ahead, etc. Which are great traits, really. The thing is, for the ordinary investor at home, it’s not easy. Choosing actively managed funds is more likely, based on the percentages we see, to result in trailing the indexes once fees are taken into account.

  4. says

    I searched through the report from the link in the article you linked to and couldn’t find the word “beta” once. “Risk” only appeared once, and it wasn’t in reference to “risk-adjusted” returns.

    Obviously beta is only one way to gauge risk, and it really only has value to those closest to retirement, but unless you account for some risk adjustment, it’s very easy to claim that active funds are beaten by index funds. In a way, it’s like saying that small cap funds always beat large cap funds, which is true, as long as you don’t account for risk.

    • Squirrelers says

      JT – you have good points here. I would suspect (not sure though) that there’s more risk in these actively managed funds than in the index funds. Why? Because ,many of these actively managed funds are setting out to beat the market rates of return. Returns without risk is a great concept, but in general we know how that plays into investments. If people want returns, they take on risks. Small stocks outperform larger stocks over the long term, but we’re dealing with higher betas too. In this case, what’s interesting is that there are fees that come into play. These fees play a big role into eroding the returns of these actively managed funds.

  5. says

    I think a combination of both is the best. Index funds are great because they charge little fees and allow you diversity. However not everything that you want to invest in can be found in an index fund which is where mutual funds come in. Using both for me is the best since you can max out your returns through diversification. The trick is finding somewhere that doesn’t charge outrageous fees.

    • Squirrelers says

      Miss T – there are actually a number of indexes around these days, allowing for diversification in many ways. A key in my view is to allocate one’s assets in a way that stocks represent an age/goal appropriate percentage of the overall portfolio. Diversificiation can also occur in that way by spreading investments across asset classes.

  6. says

    Unfortunately, there’s a lot of snake oil passing as wisdom on Wall Street. Very few managers beat the averages substantially and when they do it’s often a hot streak that they can’t duplicate later. In the pursuit of riches, we’ll gladly believe they have some sort of angle or magic touch.

    I know a lot of people will disagree with me on this, but I think the most important play on stocks is timing. There’s a time to be in, and a time to be out. It’s the time honored investment advice to buy when eveyone else is selling, and sell when they’re all buying. Index funds are the perfect way to play this, especially for the average person who has a day job and doesn’t have time to follow the market or individual companies or industries.

    • Squirrelers says

      Kevin – Buffett had a saying like this, essentially to zig when the market zags. Buy low, sell high. Anyway, it does seem like many people just want to believe that fund managers have that magic touch.

  7. says

    I did hire a guy right before the 2009 downturn and ditched him 6 months later. His fees were high, his stock picks overly complex and he ended up underperforming vs an already tanking market. Now 50% of that 401K account is in a whole market stock index fund, the other 50 in different sized index funds, small caps, large caps, tech stocks, raws, etc. I’m happy with how it’s doing now. It could use a little more tweaking but I don’t feel as exposed as I used to.

    I did it because I knew my 401K needed to be diversfied but didn’t have time to do it right. I thought farming it out would be the best thing. In reality, it was a costly mistake to allow someone else to do it and once my life got in order again, I took things back under my control

    • Squirrelers says

      First Gen – glad you were actively engaged enough to make that move to ditch the underperforming person you hired to handle your investments. Sometimes the “experts” have difficulties with picking equities well enough to compensate for the fees.

  8. says

    We were taught that active is better than passive. Doing something is better than doing nothing. After bubbles there were those exceptions who did very well and blew out the S&P, but those were one hit wonders.

    Most people feel they can do better than average or hire a so called expert fund manager and do better than average. Ego and emotions come into play and blind everyone of the stats. In this case, average is the best for the long haul!

    • Squirrelers says

      Buck – I agree that most people feel that they can do better than average. Some people sure can, but not everyone. Not even many fund managers!

  9. says

    I think the vast majority of investors would be better off in index funds. Not only does historical performance demonstrate this, but the lower fees and chasing of returns further compounds comparative losses over years. Everyone likes to think they’re “lucky” or can do better than the rest of the “idiots” out there. It’s OK to be boring, really. You’ll have more money later.

    • Squirrelers says

      Darwin – totally agree. There’s a lot of overconfidence among ordinary, everyday investors. This hubris can negatively impact one’s returns.

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