My Friend Mike is huge supporter of index funds and he is kind enough to start posting here on a semi-regular schedule about investing. Find out more about him at the end of the article and let him know what you think.
I often find myself pondering why actively-managed funds even exist anymore.
From the 1940s (when mutual funds were first created) to the 1970s, actively-managed funds made a lot of sense:
- They offered diversification for small portfolios. (Diversification with individual stocks is impossible to achieve unless you have a lot of money.)
- They allowed investors to not have to worry about watching their investments. They had a professional on the job for them. This allowed investors to gain peace of mind about their money.
Then, in 1975, Vanguard created the first index fund. Over the 34 years that have followed, low-cost index funds have proven to dominate the world of actively-managed funds. There’s a fundamental, common sense reason for this phenomenon, and there’s a giant, ever-growing pile of evidence to back it up.
The message from the markets has been clear: Actively-managed funds with costs significantly above those of index funds (Note: This is almost–but not quite–every actively-managed fund in existence.) have a very slim chance of outperforming index funds over extended periods.
So why, then, do actively-managed funds stick around? Why do so many investors still use them?
The media needs them.
As far as I can tell, the symbiotic relationship between the mainstream financial media and the active-management fund companies is the primary reason the fund companies are still around.
The media needs them for advertising. Take a look at an issue of Money magazine. Who are the biggest advertisers? T. Rowe Price, Schwab, Fidelity. (Yes, these companies do offer index funds also, but they’re primarily active-management fund companies.) So should it come as a surprise that the media gives these companies the benefit of a very large doubt in most of their content?
The media needs them for news. How many times have you read articles about the “Hottest Funds for This Year,” or about a fund manager who has put up big numbers for the last couple years using a clever new strategy? There’s always some manager who has had great performance lately. For the financial media, the active-management industry is a well that never runs dry.
In contrast, how many news articles can be written about what Vanguard is doing lately? To be honest, I can’t recall ever having read one.
To put it bluntly: When the media writes something espousing the virtues of active management (or of a particular fund manager) they’re not looking out for your best interests. They’re looking out for their own.
About the author: Mike writes at The Oblivious Investor, where he reminds readers to ignore the day-to-day market news and focus instead on getting investment fundamentals right. Subscribe to his blog for daily updates.
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{ 8 comments… read them below or add one }
The spirit of what you are saying is something I agree with.
I do find however that at times, actively managed funds outperform. If you look at net performance, this is true.
Just because ETF’s and index funds beat 80% or 90% of the funds, doesn’t mean you can’t own the top 10% or 20% of the best performers.
Look at NoLoadFundx newsletter. They rank all the funds and usually the actively managed funds outperform.
But I do appreciate your wise comments as always.
Neal: I generally agree with Oblivious Investor in the passive investing arena.
You are absolutely right in that there will always be actively managed funds who will outperform but I’d say 99.9% of all investors will never have the knowledge or time to move in and out of them to be able to take advantage. As a result, most people just buy some actively managed funds and hope that they work out. Sure, some get lucky and make a fortune, but there are just as many who bought one stock in their life and is beyond rich.
For most people, passive investing is probably the way to go.
Hi Neal. You’re absolutely right.
By default, if something beats 2/3 of other funds, that means that 33% of the funds out there still did better.
Up to you how well you trust your ability to choose one of those 33%.
As a member of the financial media, I don’t necessarily agree with this thesis. Index funds NEED actively managed funds or any stockpickers in the market. The market moves when people have opinions on individual stocks, sectors and ideas. These players include traders, pension funds, endowments, hedge funds and even actively managed mutual funds.
The trick with actively managed funds, like individual stocks, is to know when the manager’s run is done. A lot of people got caught holding Legg Mason Value Trust after Bill Miller’s fantastic run.
Actively managed funds can offer a bit of juice for an Index plus strategy.
Ari, of course actively managed funds can offer a return better than index funds, if you’re able to choose the right ones a the right times.
Explain to me, though, why index funds need actively managed funds and individual stock pickers? Long-term market returns don’t come as the result of people executing trades. They come as the result of corporate dividends and earnings growth.
Am I missing something?
Ari: While I agree that the market moves because people buy or sell securities, I don’t necessarily get how the stock prices move either. For example, if EVERYONE just sticks with index funds, you will see that people sell stocks when they need money and buy whenever they have money (for those interested in equities anyway). As the money supply in the market always increases, so will the stock market.
However, I do credit the actively managed funds for helping increase advertising on the equity market as a whole though. Without these, (and CNBC for that matter), I bet many people wouldn’t even participate and therefore the securities in general wouldn’t have a high value due to less demand.
Yes, over the short-term, markets move as a function of supply and demand. People get scared, demand goes down, and prices go down. People become confident, and prices go up.
But over the long-term, equity market returns have more to do with corporate earnings than with supply and demand.
In fact, an increased demand for equities actually leads to lower long-term returns for investors. (Greater demand for investments means higher prices. The more you pay for an investment, the lower the rate of return. That’s just simple math.)
That’s a good article on mutual funds. I do disagree however that one needs a lot of money in order to be diversified. With the advent of online trading whose costs are rapidly declining, investors managing individual stocks are on par with mutual fund managers.
I do agree however that beating the S&P 500 is next to impossible.