The bursting of the housing bubble and the financial crisis that resulted in 2008 shook many Americans’ confidence in the financial community. Considering so many fund managers completely missed the subprime mortgage crisis, it’s reasonable to wonder if money managers even know what’s going on in the market.
A handful of recent data suggests the answer is an emphatic “no.”
Many casual investors simply do not know enough about the stock market to feel confident picking stocks on their own, so they chose to invest in actively managed funds. These investors believe the fees paid to fund managers are well worth the excess profits generated by these “experts.” Unfortunately, that’s not really how it works. A mid-2016 study by S&P Global found that 90.2 percent of actively-managed U.S. funds have fallen short of their benchmarks in 2016.
Why are active fund managers having a particularly bad year this year? It turns out they aren’t. S&P Global has found similar results going back a decade. In the past 10 years, 87.5 percent of these funds have underperformed the market.
Take a minute to let that sink in: less than one out of five professional fund managers has outperformed the Standard & Poor’s 500 index since 2006. Active fund managers aren’t just having a bad year. They are doing a bad job.
If you’re an optimist, you might think that this news is no worry to the smart investors that choose one of the 10 to 15 percent of funds that are “good” funds. Another study by S&P shows that outperformance is not as simple as picking one of the best funds. In fact, there may be no such thing as a best fund.
Back in 2014, S&P looked at nearly 3,000 actively managed funds over a five-year period to determine how many of the funds had performed in the top 25 percent each of the previous five years.
The answer? Two funds.
Looking at it another way, 0.07 percent of the nearly 3,000 funds managed to stay in the top 25 percent of funds for five consecutive years. That’s slightly less than the number that would be expected to do so by random chance alone.
What is the explanation for this abysmal performance?
According to Nicholas Colas, chief market strategist for Convergex Group, it’s no coincidence that the last decade has been difficult for active fund managers. During the years of the financial crisis in 2008 and 2009, correlations among stocks were extremely high.
“That means stocks moved together more than historically normal,” Colas says. “That made outperforming more difficult.”
In addition, the rise of high-frequency trading and other computer-based trading has made equity markets much more efficient in recent years. “More people chasing fewer opportunities makes markets more efficient and makes the active manager’s life more challenging,” he says.
Mark Hebner, CEO of wealth advisory firm Index Fund Advisors, believes that market efficiency theoretically makes consistent outperformance impossible. “Active investors still exist because they do not understand the Nobel Prize-winning efficient market hypothesis,” Hebner says. “The wisdom of the crowd will always exceed that of an individual.”
Hebner says active investing isn’t far removed from a trip to a casino.
“People are lured in by actively managed funds because these funds have been sold to them by misleading advertising and/or brokers who are not held to a fiduciary standard of care,” he says. In fact, Hebner even hints at the gambling mentality of active investment in the title of his book, “The 12-Step Recovery Program for Active Investors.”
David Blake, director of the pensions institute at the Cass Business School in London, urges investors to think of active funds in terms of value. The fees managers collect and the administrative expenses of these funds make them bad investments by default.
“Active fund management, especially with equities, is a negative value-added industry,” Blake says. “In other words, active managers on average subtract rather than add value.”
If active funds aren’t working, long-term investors must determine the best alternative. Colas believes investors should remain patient with active funds. He claims the past decade is simply a normal part of a typical market cycle for active fund managers
“At some point the pendulum will swing. So it makes sense to have some active allocation,” he says.
The stock market can be complicated and intimidating to inexperienced investors. But buying a low-cost index fund such as the Schwab U.S. Broad Market ETF (ticker: SCHB) the Schwab U.S. Large-Cap ETF (SCHX) or the Vanguard S&P 500 ETF (VOO) is as simple as one click of a button or one call to a broker. These index funds are designed to mirror the performance of the S&P 500, which outperformed nearly 90 percent of active fund managers last year. They also have some of the lowest expense ratios in the market, meaning they charge investors lower fees.
If risk is a concern, owning an S&P 500 index fund is about as diversified as an investor can be within the confines of the U.S. stock market. The S&P 500 index contains…
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