Active Fund Management Is A Loser's Game

CBS Money Watch:  "Twice each year, Standard & Poor's puts out its active versus passive investor scorecard, reporting on how actively managed funds have done against their respective benchmark indexes. Every time, the results are pretty much the same, demonstrating that active management is a loser's game -- in aggregate those playing leave on the table tens of billions of dollars forever seeking alpha (outperformance, adjusted for risk)."

The following is a summary of the latest scorecard's findings:

• For the five years ending March 2012, only 5.23% of large-cap funds, 5.46% of mid-cap funds and 5.14% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.


• Looking at longer-term performance, 5.97% of large-cap funds with a top-quartile ranking over the five years ending March 2007 maintained a top-quartile ranking over the next five years. Only 4.35% of mid-cap funds and 15.56% of small-cap funds maintained a top-quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.

Obviously, the majority of investors in active funds are taking all the risks of investing and not being properly rewarded for taking those risks, transferring tens of billions from their accounts to the wallets of active managers. The question is why do they keep doing this? Evidence suggests that one explanation is that they are simply unaware of how poorly they are doing."

MP: After considering risk, expenses, turnover, and tax efficiency, most investors will be much better off investing in a passively-managed, indexed funds (or ETFs) than investing in actively-managed funds.  In most cases, you'll be paying the managers of the actively-managed fund to lose money for you, compared to a low-cost, low turnover, tax efficient indexed fund.  My advice is to avoid most actively managed funds, and instead invest your money in low-cost index funds with Vanguard or Fidelity.

For example, with a minimum $10,000 investment in the Vanguard S&P 500 Index Fund Admiral Shares, the fund's expense ratio is only 0.05% - that's just 1/20th of 1%, or $5 per $10,000 per year (that's basically free). The average annual expense ratio for an actively managed large-blend mutual fund is about 1.22%, or more than 24 times higher than the expense ratio of the Vanguard fund.  And in almost all cases, those actively managed funds will underperform the benchmark indexes like the S&P500.  Over long periods of time, the S&P 500 has consistently outperformed something like 94-97% of actively managed mutual funds, which as the article above points out, is a "loser's game."   

When the choice is between: a) passively-managed index funds with expenses that are almost zero, and with higher returns on average than actively-managed funds over long periods of time, and b) actively managed funds with very high management fees and lower returns than passive funds over time, it is almost a mystery why active funds can survive and remain so popular?