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The purpose of this article is to warn readers about actively managed funds.
You may have heard a this before as big-name investors like Warren Buffett and Jack Bogle have
repeated it ad nauseam.
We’re echoing their message here to ensure our readers understand it.
In short, actively managed funds are almost never a good deal.
Numerous
groups and individuals have studied this, and all come to roughly the same conclusion—95%
of active fund managers underperform the market.
Let's discuss some reasons why this is true.
First, realize that, before fees, active and passive investors must collective
earn the same returns.
If the market returns 20% in a period, then passive investors in that market earn 20% by definition.
The remaining investors (the active ones) must also earn 20% collectively (or the market return
wouldn't be 20%!).
So both active and passive investors earn the same aggregate return before taxes and fees.
Let's consider the taxes and fees now.
With an active fund, you must pay for the securities
plus the salaries of analysts, traders, managers, compliance personnel, etc.
Some of these workers command very large salaries.
If that's not bad enough, realize these employees require office space, human resources, computers, insurance, etc.
The fund passes all these costs (plus profit) to the investors, in the form of various fees.
The investment that earns the market return is only what's leftover after all these costs.
Taxes make this even worse.
Each time a security is sold/traded, a capital gains tax must be paid.
This can substantially reduce net returns.
For example, if a fund sells a security within a year of purchasing it, you're hit
with a short-term capital gains tax.
For high income individuals, this can be up to 37% in 2024!
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 statistically less likely to pick the high performers.
For these reasons Warren Buffett and Jack Bogle
recommend passive index funds for most individuals.
Warren Buffett 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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