Investing In Actively Managed Funds: Deal or No Deal?

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I just finished watching my first episode of Deal or No Deal, a new game show on NBC. I personally thought it was amazingly dull, but it did remind me of a good parallel to investing that I read in the book The Coffeehouse Investor (Yes, I know. Who’s the dull one?). If you’ve never seen it, that’s okay, this is a simplified version which I will explain. (You can also play an online version if you’d like.)

Let’s say you have ten open suitcases, each with a different amount of money in them:

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Obviously, if you had a choice you’d pick the one with $10,000 in it. But the Banker then closes the suitcases and mixes them all up. Next, he reveals the $8,000 suitcase. You can still choose any of the suitcases to take home. Which one would you pick?

Added: It’s interactive now! Click on a suitcase if you want to gamble.


This is similar to the situation that you are faced with when picking an active vs. passive mutual fund. Over extended periods, approximately 75-85% of actively managed mutual funds fail to match the total market average. Yes, you could pick the $9,000 or $10,000 suitcase, but do you want to take that risk? We should all the take $8,000 happily.

Knowing the $8,000 suitcase is readily available is another analogy to knowing about index funds. Otherwise, you might be walking around with the $6,000 or $7,000 suitcase thinking you got lucky… Remember, even picking the active mutual funds with the best 10-year historical returns doesn’t work! For example, the top 35 mutual funds from 1978 to 1987 cumulatively under-performed the stock market average by 7 percent annually the next ten years (data also taken from The Coffeehouse Investor.)

Comments

  1. Great analogy!

  2. I enjoy when people compare life situations to situations on television shows, movies, and songs! Your comparison was a nice and simple way to make people reconsider investing in index funds.

  3. Nice analogy…if you don’t mind, I think I’m going to share this with anyone I talk to about investing from now on. =)

  4. So I was reading this post and I got all excited because I thought I was able to choose one of the cases to let me see if I would have gotten the $9000 or $10,000 case… only to find out it’s just an image.

  5. LOL, I was trying to convince people not to gamble! :)

    But that’s a good idea – I whipped up a quick interactive version. Guess away!

  6. Independent George says:

    Not to mention the fact that you’d be paying $100 for the privilege of picking one of the mystery cases, vs around $15 to keep the $8,000 case.

  7. Good use of the Deal or No Deal for comparison sake, I like that.

    I have not read the book you have mentioned (although now I think I will have to) but I hear quite often the statistic you point out where roughly 75% of actively managed funds don’t beat the stock market. I do have some concerns about this statistic that the book may clarify, or you could expand on since you’ve read it.

    But I always hear this statistic and it almost always refers to funds beating “the market”, and most often the S&P 500 as the benchmark. My concern is that this could make that statistic misleading since the majority of actively managed funds are not trying to beat the market. Most funds have a specific style or role in a portfolio and are not meant to capture the returns of the market.

    For example, even most equity funds are not trying to mimic the market. Some invest in certain sectors, industries or by simply the size of a company. These types of funds aren’t trying to beat the market, but simply perform the best in their peer group of similar investment mixes.

    So simply because most equity funds focus on a specific niche or asset allocation and it doesn’t beat the broad market doesn’t make it a bad fund. If it under performs similar funds in the same category, then yes. But if I were to just pick some large cap growth fund a few years ago and expect it to beat the market I would be very unhappy, but alas, it could be the best performing large cap growth fund in the category and doing exactly what the fund was created to do.

    All that being said, clearly there is no argument to the fact that if your goal is to keep pace with the market that your best option is probably index funds or ETFs as opposed to picking a couple hot funds and hoping to beat the market. But if from what I read regularly about the actively managed underperformance is correct when compared to total stock market returns then I would have to argue that statistic is not very meaningful considering most mutual funds are designed to invest a certain way, in a certain sector or fill a specific goal in a more broad portfolio, which would mean it doesn’t matter if it beats the broad market or not.

    Sorry for the rambling, but maybe you can clarify a bit on the book. Does the book actually compare like funds to like indexes? Does it take into account that even many pure equity funds hold some cash positions as well? Inquiring minds want to know. Thanks!

  8. I picked the $9K and then the $10K on my first two tries! If I was only that lucky in my 401K today :(

  9. I picked the $10,000 one! Hehehe. But I suppose I’ll still stick to index funds for now. ;)

  10. “I picked the $9K and then the $10K on my first two tries!”

    Hey, me too! I bet the arrangement was not actually random, but was done by a human trying to make it look random.

  11. George – Actually, the stat is after annual expenses, but still neglecting loads, the amount of capital gains (tax-efficiency), and also merged or discontinued funds (survivorship bias).

    Jeremy – Your point is well taken. I believe the book compares all mutual funds to the Wilshire 5000 index using Morningstar’s Principia package. The book is also 150 pages long and in large print; Let’s face it, it’s very hard to shrink down all of the active vs. passive debate into one factoid. But I agree, it is not the best one I could have chosen… It just fit so nicely with the game show.

    However, I think it’s a way that the general public can relate to, and that’s why the book chose it. For example, I see ads for fund companies comparing their fund performance versus the S&P 500 all the time, regardless of their actual risk profile.

    It would definitely be better track vs. a benchmark, even though that has it’s own difficulties like dealing with style drift. For example, I could have quoted this study, which does exactly that:

    “To make comparisons between index management and active management as accurate as possible, the study segregated funds by style and then compared funds of the same style. This “apples to apples” comparison is the most accurate methodology. Many other studies suffer from some level of benchmark mis-specification or “size bias,” as they compare all actively managed funds, which include Large-, Mid-, Small-, and Micro-cap funds to a Large-Cap Blend index, the S&P 500.”

    The conclusions are much more complex, but the overall message remains the same:

    “Through examination of current and survivor-bias-minimized fund data, as well as other academic studies on this issue, we find that index management outperformed active management in most asset classes.”

    Overall, I just think that low-cost, low-turnover funds are the best, whether they are active or passive. Some of the passive funds in that study are pretty expensive for a passive fund.

    Aleks – You got it, it was me mixing it up. I re-did it again, this time using a random number generator ;)

  12. The suitcase below $8K is not working.

  13. Jonathan, thank you for digging up that study. That is a far better representation of the claim than I have read about in the past. While it does strengthen the case a bit I still have some concerns with the study and the results.

    The first thing that struck me was the sample size. The numbers appear to be a bit low considering the overall fund universe. I didn’t read in that article as to how they selected the funds in the sample. Was it every fund in that category? Was it a random sampling? It could be completely accurate, I just wish they clarified how the sample was generated.

    The only other thing I had a question with was that even though they broke things down by market cap and style which was a good start, I think more discrepancy is left on the table. For example you can have a health care fund, an emerging markets fund or a technology fund fall into one of the market cap and style categories, yet their holdings are not even close to a representation of the index they are being compared to.

    A technology fund that falls under the mid-cap value holds only a fraction of the holdings of a mid-cap value index. Given the focus of the fund on one industry it could have a significant disparity between the index.

    But I digress. Clearly between the studies I’ve seen and the book you referenced most average investors will fair better by by sticking with an index for their long-term investing needs. It is just difficult to get a true apples to apples comparison across the board.

    Thanks for taking the time to dig that up and respond, I have learned quite a bit.

  14. I picked the $10,000 suitcase the first time. Does that make me a super-investor?

    8-)

  15. You shouldn’t have made it interactive, I clicked on a random one for fun and got the $10,000 one, totally ruining the point! But my money’s still in index funds.

  16. Well, the truth is that you can beat the index funds, if you are lucky. There’s no point in sugar-coating it. Personally, I’ve clicked like 9 times have never gotten anything higher than $6,000…

  17. Deymond Lashley says:

    If one accepts the premise that all attempts to predict which funds will perform above average are in vain, then just take it a step further and put your money in a CD.

    I started buying into mutual funds in 2002, and each fund that I’ve ever owned has beaten its index at least three of the six years ending in 2006. I’d love to say that I’m an expert whose experience can’t be duplicated, but its simply not the case. I just looked for consistency (returns and management tenure). Over time, consistency will always beat the market.

  18. This is not a good analogy. Sorry to be short, but short on time. Let’s just start withthe fact that, with resources available to us, we already know which managers are the ones in the 15% that beat the indexes. That 85% didn’t beat the benchmark means 15% did. Pick one of the 15%. Don’t tell me the change, because I can name a dozen without looking that have done so over the ytd, 1yr, 3yr, 5yr, 10yr and since inception numbers. I can name 5 that have done so for at least 40 years. Also, this does not address any risk on the inbetween. If you need any stability in your portfolio, indexes don’t provide it. The S&P 500 (the 500 largest companies in the U.S.) declined 50% from 2000-2002. A full 78% of actively managed funds in the group beat it then. As Mark Twain said “There are lies, damn lies and statistics.” Please don’t use the statistics to twist the story.

Trackbacks

  1. Mutual Fund Deal or No Deal at Relentless Grace says:

    [...] Jonathan at My Money Blog (the best personal finance blog I’ve ever read): Let?s say you have ten open suitcases, [...]

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