It’s official: investing in actively managed funds is mostly a waste of money. That’s the finding of a November 2016 report by the UK’s Financial Conduct Authority (FCA), which highlights that funds available to retail investors typically underperform their benchmarks after costs.
Unproven skill set
This further confirms research by David Blake and colleagues at Cass Business School which finds that most fund managers are “genuinely unskilled”.
Princeton University’s Burton Malkiel was right more than 20 years ago; he said: "Most investors would be considerably better off purchasing a low-expense index fund than trying to select an active fund manager." Nevertheless, active funds still dominate the market, and most investors have only a fraction of their equity investments in passive funds. Why?
One big reason is that investors usually make several small errors of judgment, which combine to keep them out of tracker funds. Firstly, there is a failure to appreciate the power of compounding. Active funds charge more than passive ones, but the difference seems small: often less than one percentage point. This small difference, though, compounds horribly over time.
The FCA estimates that in 20 years “an investor in a typical low-cost passive fund would earn £9,455 (25%) more on a £20,000 investment than an investor in a typical active fund”. But people don’t appreciate this. A survey by the OECD has found that only 37% of people in developed countries understand how compounding works.
And experiments by Jill Fisch and Tess Wilkinson-Ryan at the University of Pennsylvania find that people grossly underestimate how fees compound and add up over time. One result of this is overinvesting in active funds.
Another bias is what Richard Thaler and Shlomo Benartzi call “naïve diversification”. When faced with a range of investment options, people often allocate money equally between them. Fisch and Wilkinson-Ryan show that this leads to overinvestment in active funds simply because there are more of them than there are passive funds.
This process might be exacerbated because active investors and fund managers get extra prominence both through advertising and by being quoted in news media.
Yet another problem is hindsight bias. When something happens, we tend to assign a cause – this can lead us to assume that we would have been able to predict the event in question if only we’d known enough at the time.
So we see, for example, that a company has grown enormously in recent years and believe that huge returns could have been predicted. This tempts us to entrust our money to people who claim to be able to predict such expansion. But this ignores the important role of chance. As Sussex University’s Alex Coad has shown, most corporate growth is in fact largely random.
You might think that now you know all this you’ll be able to avoid expensive funds. Not necessarily. Economists at the University of Mannheim have shown that even the most financially sophisticated people invest heavily in expensive funds which don’t do especially well.
This is because their knowledge leads them to think they can spot good fund managers. Their knowledge, though, does not give them actual skill – merely the illusion of skill.
Don’t stick around
Having made one or more of these mistakes and bought an active fund, something else kicks in: our tendency to stick with what we’ve got. Investors tend to hold onto poorly performing stocks and funds in the hope they’ll turn around. Economists call this the disposition effect. And we tend to overvalue what we have: this is the endowment effect.
Combined, these biases discourage investors from dumping active funds. Very often, investors can be wise to do nothing – but not in this case.
None of this is to deny that actively managed funds can occasionally beat the market. Some will, but perhaps only the same way somebody will win the lottery. It’s unlikely average investors can spot such funds; it’s far more likely that they buy bad funds based on standard errors of judgment.