Active Mutual Funds will Eat You for Lunch

Gargoyles on Notre Dame

Active mutual funds once held such promise. They made sense. Investors pool their money together and hand it over to professionals to manage. The experts have the training, vast research capabilities, and sophisticated computer modeling us mere mortals can’t touch. Furthermore, the experts are disciplined, experienced, and know how to succeed through special knowledge of the financial world. The pros carefully research and select securities to outperform the market and bring excellent return for their clients

The experts are consistently wrong

It turns out that most of the experts are consistently wrong. And they are worse than wrong. They appear like purveyors of fine snake oil. Research shows that over a five to ten-year time frame, more than 80% of actively managed funds under-perform market benchmarks. And over longer periods the story is even worse. Yes, some funds do well in short one or two-year windows. However, that appears more the result of random chance than expertise.

“Don’t be fooled by the argument that every year there are some ‘winners.’ It’s practically impossible to predict them. There’s no evidence of persistence of performance beyond what you would expect from random chance.” [1]

—Daniel Solin, director of investor advocacy for the BAM Alliance

Let’s look at the numbers. Head on over to the S&P Dow Jones Indices and look for the year-end SPIVA® Scorecard reports[2]. We'll look at the Canada scorecard first. SPIVA covers five years to the end of 2015. The Canadian situation is one of the better ones; nearly 34.25% of actively managed equity funds outperformed the S&P/TSX Composite index. Yay! Of course, that means that more than 65.75% couldn’t even match the benchmark result. Crap. Small to mid-cap funds fared a little better.

It gets even uglier

We don’t have 10-year numbers for Canada, but they would be ugly. For ugly, we can look at the U.S. scorecard. Note that we’re not picking on the U.S. here. It’s just that the report has 10-year numbers, and the further out you go, the worse it gets. To quote from the report, “…over the 10-year investment horizon, 82.14% of large-cap managers, 87.61% of mid-cap managers, and 88.42% of small-cap managers failed to outperform on a relative basis”[3]. For some real fun, look at the Europe scorecard. 100% of Netherlands equity funds underperformed the market benchmark over a five-year period. Ouch.

The SPIVA scorecards do a good job because they correct for survivorship bias, apples to oranges comparisons, and skewed asset weightings. It seems the active funds don’t want you reading this stuff. They play tricks such as hiding fees, shutting down or merging underperforming funds after only a few years, adjusting the timing of their one, three, and five-year numbers, and otherwise obfuscating.

Let's stop being suckers

Actively traded funds have high costs to operate and charge hefty fees to clients. They pay salaries to dozens, even hundreds of managers, researchers, and interns. They spend millions on advertising, trying to convince you they have the smarts that you don’t. And they have kickbacks to pay to financial advisors who push you into the funds. After missing market averages and carrying such high costs, how can they possibly make you money relative to other opportunities?

Finally, there are the high fees you pay to participate in all the disappointment. Most funds charge 1.0% to 2.0% of your entire investment principal yearly. Every year. Forever. There are font-end loads and back-end loads. There are fees that financial advisers charge to “keep an eye on your holdings”.

It’s time for active fund managers to step up and justify their high fees in light of such horrendous results. And it’s time for investors to stop being suckers.

 

Jon Dearden

 

[1] The Wall Street Journal (2005, March 1). Is There a Case for Actively Managed Funds? Retrieved from http://www.wsj.com/articles/are-index-funds-really-better-than-actively-managed-1425271058

[2] S&P Dow Jones Indices (2015). SPIVA® Scarecard reports. Retrieved from http://ca.spindices.com/search/?ContentType=SPIVA

[3] S&P Dow Jones Indices (2015). SPIVA® U.S. Year-End 2015. Retrieved from http://ca.spindices.com/documents/spiva/spiva-us-yearend-2015.pdf

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