Year after year, decade after decade, the actively managed fund industry fails to deliver on its promises. Yet year after year, decade after decade, investors hand their money over to actively managed fund companies in the hopes that they’ll earn above-market returns.
Why is this? As far as I can tell, it has to do with:
- The structure of the industry, and
- How enticing and at-first-glance-believable the industry’s promises are.
Why Settle for Average?
“Wall Street cozies up to you and whispers in your ear, ‘You can do better than that…Why settle for average?’” — Bill Schultheis in The New Coffeehouse Investor
It’s such an alluring message. We don’t like being average.
And every broker (or large fund company) has data to show that they can beat the market. It’s plain as day. They’ve done it before. “Look here. See these five funds? Each of them beat the market. In fact, they each beat the market by more than 3% per year.”
Who wouldn’t invest in that? It’s a slam-dunk sales pitch when dealing with most investors.
The problems, of course, are that:
- We’re never shown the thousands of funds that underperformed. (As Schultheis would say, the fund companies are “hiding their bad report cards.”)
- It’s as good as impossible for the average investor to determine ahead of time which funds will outperform.
As Kenneth French (a big-name professor in the finance community) put it in this video interview:
“Stock returns are incredibly noisy. So if I’m out there trying to hire a great active manager who can pick winning stocks, looking at their track record, it’s going to be very hard for me to decide they performed so well because of skill [or] they performed so well because of luck.”
A Stock Picker’s Market
The other most common lie from the active fund industry is that “this is a stock picker’s market.” This lie comes in one of two forms:
- “In a roaring bull markets like this, expert management can really show its value.”
- “Our expert management will protect you in a down market.”
At first glance, either one of them seems to make sense. However, the fact that they argue that active management is especially good in both up and down markets is a clue as to the lack of truth behind the assertion.
And as William Sharpe famously pointed out, the arithmetic of active management must hold true at all times, over all periods. Kenneth French puts it this way:
“This is not a statement that over the long-haul, I expect on average to win. It’s not every five years. It’s not every three years. It’s not even every month, or every day, or every second. It’s every instant. Every instant, I know that the return on my passive market portfolio is going to be higher than the value-weighted average of everybody else.”
Once it’s framed in those terms, index investing sounds pretty enticing itself, doesn’t it? 
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{ 3 comments }
I must admit I fell for the “Why Settle for Average?” argument- but not for a mutual fund but for picking individual stocks. And at some points I did really beat the market handily… of course if you make a few mistakes where a picked company goes to zero then all those extra gains disappear.
I always had to worry- show I sell NOW? With an index fund you don’t have that worry- if the majority of companies in VT go under your portfolio is the last of your worries.
-Rick Francis
One of the most eye opening investing books that I have ever read is Burton Malkiel’s “Random Walk Down Wall Street” which makes exactly the same point that you are making.
It’s all one big marketing plan. The easiest is to just stick with Vanguard or ETF’s.
In fact, ETF’s are the best. Don’t overthink things!
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