A good story really helps to spread an idea. The story told by the actively managed mutual fund industry goes something like this:
“Index funds are for average investors. You are smarter than average, aren’t you?”
That’s the sales pitch behind the entire industry. And it’s a fairly easy pitch to make given that most people really do think of themselves as smarter than average.
So in the minds of many investors, the comparison between index funds and actively managed funds has been framed this way:
- Index funds give you average (i.e., mediocre) returns.
- Actively managed funds give you a chance at better-than-average returns.
Telling a Different Story
How can we rework this story to be more truthful?
I’d try something like this if I were comparing, for example, Vanguard’s Short-Term Bond Index Fund to actively managed bond funds:
- This fund has outperformed 85% of its competitors over the last 10 years.
- This fund’s strategy mathematically guarantees that it will continue to outperform the majority of invested dollars competing against it.
Focus on the math, not the performance.
Important note: It’s point #2 that makes index funds such a good bet. Point #1 is only there to provide an introduction to (and evidence of) point #2.
Too often, people say that “index funds have outperformed x% of actively managed funds,” and they leave it at that. But if we’re making comparisons based purely on past performance, there will always be a handful of actively managed funds that have done better than the comparable index funds.
The real story of index funds vs. active funds is the one William Sharpe told almost 20 years ago:
“It must be the case that
- before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
- after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.”
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Thanks for pointing me to that William Sharpe article. This makes it a lot easier to explain the advantages of index funds to others.
Something very similar can be said for taxes to.
So true. It’s why I’ve gone down the road of index tracking rather than active management whereever possible. The negative from my side is that being based in the UK index tracker funds/ETF’s still have extremely high fees compared to the US.
With my retirement investing strategy my average fees for my total asset allocation is still running at 0.6%!
I found that Bill Schultheis’ “Outfox the Box” provided a good illustration of the difference between active mutual funds and index funds. He does perhaps exagerate the difference, but taking fees into account he probably isn’t too far from the truth.
http://www.coffeehouseinvestor.com/?page_id=7
RJ: Sharpe’s Arithmetic of Active Management is arguably my favorite article/paper ever written about investing–concise, understandable, and unassailable logic.
RetirementInvestingToday: We are indeed lucky here in the US. Still, you’re paying a lot less than even some of us yanks.
Blair: Agreed. I’ve always liked that analogy.
How true – and thanks for the link to the Sharpe paper.
But the argument is even stronger: even if fees were the same for both active and index funds, index funds would still be the right choice for most investors.
Any investor who is risk averse will prefer an expected return of 7% plus or minus 1% to an expected return of 7% plus or minus 3% – it’s simply rational to minimise your uncertainty if the expected outcome is the same. Now consider that (ignoring fees) the index fund gives you the average market return for certain, and that active management will give you the same return (on average – mathematically anything else is impossible), though some funds will outperform and others will underperform. If the expected return is the same, which option do you choose: get it for certain, or roll the dice?
QED.
P.S. Mike, you should set up a tipjar for this blog – your work is well worth a few tips
This site makes it easy: http://tipit.to/
Niklas: I absolutely agree. Even in the absence of fees, I don’t see active management as a “value-added” service.
As to the tipjar, that’s a neat idea. (And thanks for the kind words!) So far I’ve been trying to stick with monetization strategies that help people at the same time as providing me an income–books, most particularly.
@Niklas – Great point. One of many reasons why I always steer friends who ask towards index funds is I know they’re not going to underperform. Most people hate losing money. A neat illustration of how ably the fund mangement industry obfuscates away its relatively poor performance is that most active investors don’t realize they’re doing worse.
@Mike – I think there’s an even simpler reason for why active investing appeals than playing to people’s mental egos. Basically, if you don’t spend your time researching this stuff up, it’s counterintuitive to the average person that paying for a persont to do their job does less well.
Where else is that true? We don’t say you get drugs randomly from a robot as well as a doctor, or take legal advice from a schoolboy.
You and I (and Sharpe) know it’s not the same thing at all, and it’s why you’re right of course to focus on the maths, but for the average person who in most walks of life pays more and sees a better product/service, passive investing is incredibly counter-intuitive.
Monevator: You’re absolutely right. I often forget about how counterintuitive the whole idea is. (Once you’ve had the math explained, it’s plain as day.)
I think index funds are the way to go. Overall, they will outperform the average actively managed fund. In this market, who trusts fund managers anymore?
Index funds will overall beat the average fund manager. How could you trust your money to a “professional” who probably can’t even beat an average return earned by an index fund.
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