The Actively Managed Mutual Fund Racket

Timothy B. Lee -- Writer with Ars Technica and the Cato Institute

While I didn't discuss it in detail, one of the implicit points of my last post is an endorsement of index investing. That's the investment strategy that tries to replicate the performance of the market as a whole, at the lowest possible cost. The alternative is to buy into an "actively managed" mutual fund, which has a professional manager that tries to pick assets that will produce above-average returns. I claim that because active portfolio management costs more than passive management, the real-world returns of actively managed funds tend to be lower than passively managed ones.

Reader Moneyrunner disagreed with me:

If you invested in the vaunted, low cost, Vanguard 500 Index fund for the 10 years from 2000 to 2010 the good news is that your expenses were low, the bad news is that you lost money. For comparison, one of the biggest actively managed funds with expenses that are nearly 10 times higher than Vanguard's index fund - Growth Fund of America - made 13%. The truth is that in Bull markets, index funds do well partly by definition. Laggards are dropped from the index and indexes are weighted toward the largest market capitalizations. It's when markets fluctuate or go down that having active management becomes important.

This is reminiscent of a dealer at the casino arguing that his craps table will be a good deal tonight because one guy tripled his money last night. There are hundreds of actively-managed mutual funds out there. Obviously, with the advantage of hindsight you'll be able to point to examples of funds that did better than average. The question is whether there's a reliable way to identify such funds in advance.

There have been numerous studies comparing index funds to actively-managed ones, and they almost always reach the same conclusion: index funds consistently beat the average actively managed fund. This is for a simple reason: it's hard to consistently beat the market, but it's easy to waste money trying to do so.

But even if the average actively managed fund performs poorly, isn't it possible to find an individual fund that will beat the market? The problem is that it's impossible to know if a manager's past performance was the result of skill or luck—and most of the time it's luck. People point to Warren Buffett as an example of a guy who was able to consistently beat the market for decades, but he's famous precisely because people like him are so rare. And it's much easier to identify such people at the end of a long career, when it's too late to do any good.

If you were trying to decide how to invest your money in 1980, buying shares in Warren Buffett's Berkshire Hathaway would have been an option. Buffet had a couple of decades of solid performance under his belt and many people did invest with him. But Buffett was just one of many investors who had enjoyed above-average returns in the 1960s and 1970s. If you'd picked one of the other guys with Buffett-like results during the 1960s and 1970s, you almost certainly wouldn't have done as well in the 1980s, 1990s, and 2000s. Indeed, Buffett himself is a fan of index investing, betting in 2008 that an S&P 500 index fund could out-perform a collection of hedge funds over a 10-year period when fees are taken into account.

It's extremely difficult to identify, in advance, particular actively managed mutual funds that will consistently beat the market as a whole. But it's practically guaranteed that, on average, such funds will under-perform the market as a whole due to their high costs. So the smart investment strategy is to replicate the performance of the market as a whole at the lowest possible cost. And that means choosing passive money managers like the good folks at Vanguard.