One of the fundamental principles of economics is the “scarce resource” problem. In short, we (humans) have a limited supply of resources with which to attempt to fulfill an essentially unlimited list of wants and needs.
When you use a mutual fund manager to invest for you, you’re each contributing a resource:
- You’re contributing capital, and
- The fund manager is contributing his/her skill (whether good, bad, or neutral).
Which of those is the more scarce resource?
- If the fund manager has above-average skills (i.e., the ability to consistently beat the market on a pre-cost basis), certainly that’s a scarce–and therefore valuable–resource.
- Your capital, however, is no different from anybody else’s capital. Your dollars are perfectly interchangeable with everybody else’s.
So who should expect to earn an above average return for their contribution? The fund manager. Kenneth French explains it this way:
“As soon as any manager demonstrates any ability whatsoever, money will flood in and dilute that expertise–spread it over a larger base until essentially it’s gone.”
End result: The skilled manager–the one providing the scarce resource–receives the additional return (because he’s paid a percentage of assets under management), and the investors earn average returns for their average capital.
Earning Above-Average Returns with Mutual Funds
In short, in order to earn above-average returns using actively managed funds, you need to provide a scarce resource as well: The ability to select skilled fund managers prior to the rest of the market finding them.
For a few reasons, this is no easy task.
First, because the majority of actively managed funds underperform low-cost index funds, finding an above-average active fund doesn’t cut it. You need to find well above-average active funds if you want to beat a simple index fund.
Second, because most investors are so easily lured by high past performance, by the time you have enough return data to tell with a reasonable degree of certainty that a manager is skilled, it will likely be too late. In other words, you need to perform this manager-selecting feat using something other than return data.
Third, as with picking stocks, it’s unlikely that you’ll have access to any information that’s not available to the rest of the market.
Good luck!
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