As anyone can see, I like to invest my investment portfolio in passively-managed mutual funds. There are numerous reasons for this. For one, the average actively-managed fund underperforms the average passive fund. In addition, even if a fund does well up to a certain point in time, it does not necessarily to do well later. In other words, you can’t pick out the superstars ahead of time by looking at performance.
But still, from time to time, I may take a second look at certain managed funds. One example is the sometimes-persuasive writings behind the Hussman Strategic Growth Fund (HSGFX). Or perhaps something not a mutual fund but similar like Berkshire Hathaway (BRKB). But I never buy them! Here’s why:
Higher Fees
The most obvious hurdle remains one of the largest. Actively managed funds have higher fees. The more the mutual fund makes, the less you make. They have so many ways of making money – fees when buying (front-end loads), fees while selling (back-end loads), fees while holding (management fees)… they even make you pay for their advertising costs (12b-1 marketing fees). Can the fund keep covering this and more?
What’s Their Secret?
In the beginning, most funds start off with their own unique plan to take advantage of some specific market inefficiency. If the fund manages to maintain a streak of good performance, word will soon spread. Others will start to scrutinize the manager and their trades in order to see what their methodology is. If they figure it out, whatever that market inefficiency was will soon disappear.
Asset Bloat
Even if the other pros don’t figure it out, other investors will still pour in money, and sooner or later a successful fund manager will then be dealing with asset bloat. It’s one thing to buy a 0.003% position of a mid-sized company, it’s another to be buying a 3% share. Certain buying opportunities will disappear completely due to a lack of available volume. When the manager does to buy something, they will be faced with ‘market impact’ – higher prices when buying, and lower prices when selling. This hurts performance – even Warren Buffett acknowledges that he will have a much harder time beating the S&P 500 with such large assets to manage.
A good fund manager will close the fund to new investors before this becomes a problem. But this inherently conflicts with the goals of the mutual fund company: Less assets = less profits. So often a fund will drag its feet before finally closing the fund.
Playing To Win Turns Into Playing Not To Lose
Another factor comes into play with large asset bases. Perhaps the fund has indeed closed. With no new investors, now their main goal is to keep people from taking money out. They are perfectly happy with the status quo – I mean, if they closed the fund they’re probably already making tens of millions of dollars a years in fees! Secretly, the rallying cry changes from “let’s beat that market to a pulp!” into “careful… let’s not lag the market by too much, okay!”. Voila, you now own a “closet index fund”.
A rough analogy would be with interest rates from banks. If everyone else if offering 5%, and you offer 6%, people will start rushing over. Now, what happens if you gradually drop back down to 4.9% with everyone else? Most people won’t be bothered to move banks again over a 0.10% difference and will simply keep their money with you, in the hopes of reliving those good ole’ days.
Managers And Performance Comes And Go
Finally, over time, managers and their styles will come and go. They may move to another company, get bored, get sick, or whatever. Most likely, their returns will start to falter for a while and they’ll simply be replaced. Will the fund keep on course? Do you want to stick around to find out?
When Do You Bail Out?
Now, let’s say your fund does well for 10 years. But then it starts to lag. How long do you stick around? 3 years of sub-par performance? 5 years? A decade? It would drive me crazy having to worry about that. I want a fund that I can hold indefinitely.
Summary
In the end, I ask myself: Even if these guys seem really smart right now, will they will continue to beat a diversified passive portfolio for the next 40 years? If they do, they would have to overcome their self-imposed additional expenses, close to new investors early, and keep performing well despite financial incentives to simply mimic the markets. There are just too many conflicts of interest for me.
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I’m not extremely familiar with mutual funds but I’ve read that one of the most important aspects in picking a good mutual fund is picking one with a lower expense ratio.
So then I researched a little bit and learned about ETF’s. (You should probably do your own research but…) they basically have much lower expense ratios than mutual funds and have the same performance.
Once I get rid of my debt I’ll be buying a few different ETF’s with expense ratios much lower than 1%.
I stay away from active management just because of all of the fees. After the fees are all said and done the returns aren’t much different. Unless the fund is performing 12 – 20% like some may claim, I don’t see any real advantage. And even the ones that claim the 20%, that’s usually before fees.
Exactly…
Here’s a link to some information on ETF’s if anyone is interested:
http://en.wikipedia.org/wiki/Exchange-traded_fund
No argument from me.
Bas: if I were starting out today, I’d probably do ETFs as well.
I’m not making an argument for or against active funds, but just wanted to clarify something that Kristofer said that could be misleading for some. When you are researching funds, for example on morningstar or yahoo, whether it is an active fund or index or whatever, the actual returns listed are AFTER expenses, including 12b-1 fees.
So, you can’t take fund A with a 0.5% expense ratio and a 10% return and fund B with a 1% expense ratio and an 10% return and say that fund A is better because it has a 9.5% return as opposed to a 9% return in fund B. They actually both returned 10% after fees.
Again, lower fees will almost always be beneficial in the long run, but I just wanted to point out that when you are comparing funds, you don’t subtract the expenses after the reported return since it is already factored in.
There’s no reason managed mutual funds can’t be part of your portfolio. If there’s a fund you like and the research looks good and it fits into your portfolio and asset allocation, allocate some money to it.
Really well thought out position, and one that I happen to agree with.
One point to add to what Jeremy said…actively managed funds also tend to have more asset turnover, making them generally less tax efficient than index funds. So while the performance stats on yahoo are after-fees, they are not after-taxes. Just one more wrinkle to look into.
Thank you for the clarification Jeremy. Also, on this subject, can anyone suggest any good books? I was actually at the book store last night fighting with myself if I should buy the new Greenspan book. I was looking in the investment and finance section and NEARLY EVERY book was about get rich quick, “with my methods you can make easy money…” it’s just horrible to see. Get rich the EASY WAY. ugh, it’s just awful. Like anyone would take the hard way if there were an easy way.
I’ll point out Hussman’s fund is one of the least expensive of the long/short funds. However, you are taking on active managerial risk in a type of fund that takes active management to extremes over a long only stock fund.
Individual investors appear to want to pick one long/short fund such as Hussman’s for some fixed percentage such as 10%. They are wanting the hedge fund because of benefits of low volatility, low correlation with the market yet they are taking on high risk through concentration of managerial risk.
When the Sowood hedge fund Harvard invested in lost half its money Harvard admited to losing 0.9% of their portfolio. This means Harvard limited individual hedge funds to less than 2% to lessen concentration of risk in a single manager.
Individual investors need to keep this in mind if they are going to invest in hedge funds like Hussmans. They are trading one type of risk for another.
Paul
In general I agree, I think many actively managed funds are poor performers with high expenses. Unless you’re investing in a particular sector for a particular reason they don’t make much sense. That said, I do think there are some solid fund active management companies. Dodge & Cox comes to mind.
Kristofer:
I just read a couple books recommended on the Vanguard Diehards forum (diehards.org), The Four Pillars of Investing and The Intelligent Asset Allocator. Both are written by William Bernstein.
Actually, My Money Blog has a review of The Four Pillars of Investing, https://www.mymoneyblog.com/archives/2004/12/book_review_the_6.html .
I understand the arguments, but when it comes to a company like Vanguard, I feel they have the best chance to outperform with their actively managed funds since they are so so cheap.
@Kristofer:
My favorite investing book of all time is Burton Malkiel’s A Random Walk Down Wall Street. It was the first book I read, and led me down the path of indexing, passive management, and low costs.
Other good books to read are:
Four Pillars of Investing by William Bernstein
The Only Guide to A Winning Investment Strategy You’ll Ever Need by Larry Swedroe
Unconventional Success by David Swensen
The Swensen isn’t an easy read (particularly for the first third of the book), but it contains a lot of great information and insight.
“After the fees are all said and done the returns aren?t much different.”
Actually, the average actively managed fund underperforms its equivalent index. I forget the exact number, but I believe it’s around 2 ~ 3% per annum. Historically, about 70% of active funds fail to beat their benchmark.
“Actually, the average actively managed fund underperforms its equivalent index. I forget the exact number, but I believe it?s around 2 ~ 3% per annum. Historically, about 70% of active funds fail to beat their benchmark.”
I agree to an extent. a lot of that 70 % are fly by night just got my brokers license fakes. Reputable actives are the ones I was referring to, which, if they do outperform, do it by marginal % at best.
I am surprised no one commented on BRKA-as-mutual-fund; I would put my money with Buffett-Munger long before I would so do with any active open-end fund manager. Buffett has said BRK investors should not expect the 20%+ annual returns going forward, but he also hasn’t said he will *underperform* the S&P500 index (he only said it would be tough to beat it). What is BRKA’s mgmt “expense ratio”? Buffett gives investors the advantage of being focused on absolute returns (Rule #1 “Don’t Lose Money”), whereas open-end mutual funds are pinned to relative returns (Rule #1 “Don’t Look Bad Relative To Peers”), as you indicate with the “closet index fund” point.
Regarding the ETF comments, I would be careful. ETFs are in danger of becoming the next investment fad (if they have not already), and so one must be particularly diligent to select the ones with the rock-bottom expenses, and then only those that are aligned with conventional asset classes. (Avoid those exotic asset-slicing ETFs that have begun to appear.)
I have Vanguard ETF’s in my accounts. Very low expense.
VTI is the total US stock market.
Very timely post- I expect savvy (albeit risk taking) investors to start pouring a bit more money into mutual funds than money market accounts.
The opposite has been true lately, as you can imagine.
these things usually follow the stock market. If the market is going up, ETFs and managed funds will swell. If it’s going down, people get scared and pull money out.
Well you cant really compare mutual funds to BRK. Birkshire is a holding company that has diversified in many businesses. Furthermore the cash that it generates is invested in some of the best run businesses and is managed by Warren Buffet. Mr Buffet’s stock turnover puts the least managed mutual fund to shame. A significant part of my portfolio is in BRKB and I am proud of it.
Does anyone actually have hard data to show that index/passively managed funds do better than actively managed ones over the long run? I’d like to read that because I do not wholly believe it. Why? If passive funds were that much better, then no one would buy active funds because it wouldn’t make any sense to do so. Why earn 8% when you can earn 10%?
I’m not much of a funds guy anyways because I can’t see the point of paying expenses anytime that I do not need to. The only time I really stray away from this is with REITs or micro-cap funds in my investment accounts or in something like my business’ 401k.
KRISTOFER,
The Intelligent Investor by Ben Graham. It’s a decent book to read if you’re familiar with the market already. However, like many financial books, 80% of it is filler material while the other 20% is the info you want.
One caveat to *completely* avoiding cost-based funds is (imho) a situation like what I’m in.
I have my own Roth IRA………BUT……..
If I want to partake in my employer’s SIMPLE IRA plan, then I have no choice but to invest in loaded funds.
Benefit is………….I get matching and I make sure I get up to whatever max-match is & leave the rest to my Roth. It’s basically FREE MONEY up to the point of match. And, sure, the funds suck wind (Don’t tell Morgan Stanley…..they think they’re reeeeeeeally smart) 😉 but us Bogleheads know better.
Buy & hold EVERYTHING w/ as little cost & intervention as possible until such time in which you need to withdraw!!! 🙂
You make a very good point about today vs the future on these funds. Maybe these guys are doing great today and the fees won’t be terrible compared to the returns, but who knows if that will continue? Stay away from these and go with low expense and no load funds.
Do you know any funds which let you bet against currency?
I want to bet that dollar will go up within couple of years.
Yes, Buffett certainly has less restrictions that an open-ended mutual fund, which I’m sure is part of his performance edge. Mutual funds have a rule that they can’t own more than 5% of a publicly traded business, or something close. Buffett can own 100% of a business.
I’m not going to be morbid here, but is Buffett’s prowess and profound discipline unique to him or is it transferable to his successors? I’m not so sure. The low turnover will help for a while, though.
—
This is ironic, but I’m going to be buying some active Dodge & Cox funds in our 401ks later this week, due to limited buying options.
Jonathon,
It’s interesting to note that the two actively managed funds you mentioned, the Hussman Fund and the Dodge & Cox funds, are the two that Im planning on starting IRAs with as soon as I can save up the $1000 a peice for each one to start.
Here’s why I like the Hussman Fund:
Since inception sometime in 2000, its up about 150% vs about 10-15% for the S&P. However, over the last 3-4 years it has actually underperformed the S&P somewhat due to the fact that Hussman considers conditions to be overvalued and is thus hedging. I feel that this fund is a good way to diversify against the market falling, while at the same time it has a good shot at outperforming over the long run.
As for the Dodge and Cox funds, in the last couple days I’ve read and been advised by a couple people I trust for financial information (mainly because they have done very well themselves) that the Dodge and Cox funds are excellent places to put your money.
However, as I save more money and grow my portfolio I still plan on putting a large part of my money into Vanguard Index funds.
Aurelien
Actively managed funds don’t necessarily mean high fees. There are plenty of funds charge less than 1% expense ratio and their performance are OK compared to index funds after the expenses. I have 10 actively manged funds in my taxable accounts and the highest ER I pay is 1.50% for a gold fund. Given the performance, that 1.50% is not a problem for me.
Also people who just start investing, the $3,000 initial requirement for Vanguard index funds could be a problem for those don’t have a big amount of money to invest from the beginning.
As I remember, only the income fund and international fund from D&C are still open to new investors. Jonathan, you should get the international fund before it closes 🙂
I love the asset bloat theory–people drag out Fidelity Magellan every few months and use that as an example of asset bloat. Look at Fidelity Contra Fund and The Growth Fund of America talk about bloat but they are up about 16 and 13 percent respectively this year. Your problem is you don’t trust your instincts your are a slicer and dicer at heart. If you want slow steady returns then why chase all the fads. Fads to me are more than 25% foreign, more than 5% REIT, and more than 5% emerging market. If you have no pension (i.e. work for the gov. where taxpayers are on the hook) then you should be in about 15% bonds too. Your foundation should be large US cap stocks (I know boring) but P&G is more stable and is in a country that is more stable than any BRIC country. I advise people to invest in index funds because most people don’t know what they are doing and are scared of the markets. However, I invest in a combination of index and actively managed funds, which I think you should too. Pick one actively managed fund and you will have more fun watching that than any index fund.
I have to disagree with the premise of today’s post. Picking the “right” managed fund requires the same level of research as any other part of your portfolio. And regardless of passive or active, they go up and they go down. What matter is when you put the money in and when you take it out. For example, I could have been passive from 1990 to 2001. Taking the money out in 2001, regardless of the type of fund would have been a major loss because the correction at that time (don’t hold me to the day) was severe enough to wipe out a good number of years of savings. But if I held on until 2006, I would have made that money back and more and then I could say my passive fund did very well. Did it really? In fact it did the same over all up or down. What made the difference is when I cashed it out, which is your real profit or loss. I currently have active funds in domestic and international. If I was to cash out today, I would say to everybody international was the way to go, great returns, etc. Domestic stinks. But does it? In five years, Brazil may be bankrupt again, and GE may double it’s share value due to some great invention. Vice versa.
It’s like dad told me with comic books when I collected them as a kid thinking some day they would be worth bucks: they’re only worth what you sell them for.
most indices are weighted by market cap, so some overpriced stocks are overweighted. There is still some opportunity for an actively managed fund to acheive some alpha, which an index fund does not have.
Paul, you could buy UUP (PowerShares ETF Dollar Index).
I was in actively managed funds for a decade before swithing to index funds. Here’s a major advantage for index funds — tax efficiency. I got dinged nonstop with taxable capital gains from portfolio turnover. Even if all my funds had the same performance/expenses as indexes, I took at least 1% penalty from paying the annual tax bill. Of course, the actively managed funds as a whole performed a bit below the indexes. (If you only hold 2 or 3 funds, it’s possible to outperform indexes — if you have 7 or 8 funds, it’s nearly impossible.)
@Ty:
There are tons of books out there that provide indisputable data that shows active management loses in the long run. Check out anything by Malkiel, Swensen, Bernstein, Swedroe, Ferri, Bogle, etc.
Why does active fail? Management fees, expenses, high turnover, poor tax efficiency, excessive trading costs, cash holdings, style drift, asset bloat… and I’m sure there are more reasons I’m forgetting right now.
It’s also important to keep in mind that when comparing active funds to indexes that you are comparing apples to apples. Everyone likes to compare fund performance to the S&P 500, but not all funds are large growth.
This post is just how I thought through my own decision. There’s no way I could properly encompass the entire passive v. active debate in one blog post. There are plenty of carefully constructed studies and articles looking at decades of data already, some by Nobel-prize winning authors. Read up at AltruistFA:
On Passive vs. Active Management
From the first article on the list: “If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period.”
On Persistence Of Alpha (Superior Risk-Adjusted Returns)
“The root of this issue is whether it is possible for ANY actively-managed mutual fund to consistently achieve superior risk-adjusted returns. This is an important question. If the answer is no, then it implies that actively managed funds should be avoided (because they tend to be more expensive). If the answer is yes, then it inspires a separate, but equally important, question of whether it is possible to identify the few funds which will consistently outperform in advance… The majority of well-done studies tend to support a lack of persistence for all but the worst performing equity mutual funds.”
I respect everyone’s right to agree or disagree. Everyone must do what they think is best to achieve the best chance at the best risk-adjusted returns, and that’s what I’m doing. This is what I think:
Everyone should track their personal dollar-weighted rates of return, and we’ll compare numbers in 25 years. I’ll do so in public. Ideally, you would calculate your standard deviation as well to estimate risk taken. Taxes will be a bother, but we’ll see what happens. Sound good? 😀
I have a different perspective.
I was doing pretty well financially in the mid to late 90s, so my wife and I were investing as much as we could. We were big believers in the no-load index fund approach and the popular recommendation at the time was to just put your money in the S&P 500 and forget about it for 30 years.
Well, that’s what we did. We have still never sold any of our S&P. But you know what happened after 2000 when our portfolio was cut in about half. In inflation adjusted terms we’re still *way* under water and would have been much better off in treasuries.
Don’t misunderstand me. I’m not against the passive approach at all, and like I said, we still have those positions and we hope to achieve an acceptable return by the time we’ve retired.
But what I learned is that VALUATION MATTERS. It always and everwhere matters. It matters in housing and it matters in stocks.
I don’t believe you can’t pick quality managers or that it’s inherently impossible to value anything. So I look for very experienced mangers with a long record of market beating returns, low expenses, a share-holder oriented culture, large personal stake in the funds, etc.
Those names would include Dodge & Cox, Fairholme, Marty Whitman, Weitz, Nygren, etc. And I do own some Hussman although his track record isn’t very long.
Over any given interval some of those names are going to underperform relative to the indexes, but I’m interested in long-term performance and I sleep better at night knowing I have an experienced team of value managers ready to defend my investments and unwilling to chase the indexes.
Best wishes.
ooooo, Jonathan just called us all out. ha. good blog Jon. This was a fun discussion, and thanks for the book suggestions everybody!
A big problem with actively managed funds is that you have no control over the capital gains. This can be very annoying for tax purposes. But I’m happy to recommend them anyway — the more fools in the market the more money the rest of us will make.
You know, many “passive” indexes are actively managed: link