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What if you want to invest in active funds?

The videos we’ve been featuring every week on Monevator from Sensible Investing TV have done a sterling job of reminding us why passive investing via index funds is the best bet for most people.

Index investing makes sense mathematically – because active investing is a zero sum game – and also because the vast majority of active funds fail to beat the market over the long-term, not least because their higher costs turn that zero sum game into a markedly losing one.

Even Warren Buffett – one of the greatest stock pickers of all-time – says you should probably use index funds.

But most people don’t, perhaps because:

  • They’re not aware the theory and evidence favours index funds.
  • They want to try to beat the market anyway.
  • They find active investing more enjoyable, despite the downsides.

Does that sound like you? This video has a few tips on what you might consider if you’re determined to invest in active funds:

A few things to consider with active funds

It would take multiple articles to really dig into investing in active funds – and to be honest I’d probably outsource writing them to somebody keener – but I will share a few thoughts.

The first thing I’d say is that unlike some of the more extreme passive investing propagandists, I don’t think investing in active funds is a nailed-on road to ruin.

You can invest steadily in a portfolio of active funds for the long-term, and end up with a good result. Yes, very likely not as good as if you used index funds due to active funds’ higher fees, but that’s what the other videos in this series have been about so we won’t repeat it here.

Investing in active funds is at least a bit cheaper than it was now initial fees have been scrapped. Note though that some pundits believe annual costs have actually increased, albeit in a sneakier fashion.

And costs as always matter when investing.

Many of those who tout active funds – particularly expensive hedge funds – say that once you go active you shouldn’t be concerned about costs but simply performance, but that isn’t true at all.

The same remorseless maths that makes trackers the optimal choice also helps lower cost active managers in their quest to beat the market. So I’d avoid any expensive funds, especially those with performance fees.

I’d also avoid most new funds, fad funds, closet trackers, and investing in anything you don’t understand.

What have you done for me lately

What about past performance? Should you pick a past winner?

This is a thorny subject. On the one hand, as Oblivious Investor put it in his overview of research into this area:

“…picking funds based on superior past performance proved to be less successful than picking randomly.”

That’s hugely counter-intuitive, but many things about investing are.

I’d be lying though if I claimed that I wouldn’t check out past performance if I was looking into an active fund (and I have done previously where I’ve bought, say, closed-end funds). Hey, I’m only human.

And also, you know, Warren Buffett…

Still any such peek would only be one part of my wider research into a fund’s strategy, its positioning, what risks it’s taking for its returns, and so on.

As discussed below, I would explicitly not be looking for a strong recent performer and piling in!

Income investment trusts

I’ve previously admitted to a soft spot for investment trusts – ideally bought on a discount – and in particular I think well-established UK equity income trusts are a good option for private investors who want to pursue an active route.

Make sure you understand how discounts and premiums work if you do invest in them, and be sure you’re bedding in for the long haul.

One reason I like income investment trusts is that there are quite a few established funds out there.

Also their mandate to deliver a growing income focuses the manager’s minds, and keeps them largely sticking to the knitting. This is important because a consistent management style is one of the most important factors in an active fund.

In contrast if you buy into a flighty fund manager, you’re in danger of investing in one who shifts style at the wrong time to chase performance, reducing the fund’s returns.

Of course theoretically a very skilled manager might shift style at the right time.

But I wouldn’t fancy your odds of finding one.

Mind the behaviour gap

On that last note, remember that investors can be their own worst enemies.

They chase performance and dump funds at the wrong time, which means they don’t even enjoy what gains active investing might deliver them. (Yet another reason why the strategy of passively rebalancing is such a potent concept).

Blogger Ben Carlson recently showed how poorly an average investor in the highly-regarded but also highly-volatile US Fairholme Fund had done, compared to the returns posted.

This graphic gives a summary:

Fairholme

The table shows that over 10 years the Fairholme Fund delivered 10% in annualized returns, but the typical investor actually achieved around 5%.

Investors’ attempts at timing in and sell out of the fund halved their returns.

I believe this sort of thing is more likely to happen when you invest in active funds, because you’re inevitably going to be thinking a lot more about whether your manager has still ‘got it’ when they go through a tough spot, and so on.

In contrast, a good index fund investor accepts they know nothing, and instead just invests passively and rebalances occasionally, which reduces the risk of performance chasing.

Still, despite their strategy many passive investors do suffer from these behavioural problems too, and so they’re not an automatic strike against active fund investing. (We’ve got enough of those to be going on with, anyway!)

If you want a few more thoughts on pursuing an active fund strategy, please see my commentary after the third video in the series.

Check out the rest of the videos in this series so far.

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{ 17 comments… add one }
  • 1 Edward October 16, 2014, 7:53 pm

    Thanks for another excellent article. I’m struggling with this at the moment. I have a wholly passive portfolio except for my Emerging Markets fund First State Global Emerging Markets Leaders. It isn’t new, a fad or a closet tracker, and by all accounts has done extremely well. It has soft-closed now so if I sell I can’t buy it back. But it charges 1.5% and I don’t believe in active management at all. Agony!

  • 2 ermine October 16, 2014, 8:35 pm

    Active investing does not equal buying active funds. Accepted that buying active funds may be what most people do if not investing passively.

    I am an active investor. I have never, ever, bought an active OEIC, or indeed any fund that isn’t passive. With the possible exception of IUKD, which claims to be passive but is closet active in my book 😉

    I do buy and hold investment trusts, indeed ones mentioned on this very site and perfectly happy I am too. And I do buy and hold individual shares. I was sold by earlier rants on here and elsewhere that active funds are a rum deal in general, though I’m not personally sold that passive investing is the answer. But if you gotta do funds, yes, passive is probably best.

    Just leaning against the implication here that active investing = active funds, which is what this series seems to imply. Active investors may all be on an express train to investing Hell, but they’re not all pulled by active funds locomotives…

    And some of their whiskers are twitching at the possibility of a jolly good market crash. As I seem to recall a certain TI did a while ago

  • 3 The Investor October 16, 2014, 9:28 pm

    @ermine — Yes, that’s true. When writing commentary about these videos, it’s tedious to go through the seven levels of investing 101s every time, I think it’s pretty clear that they’re contrasting active funds with passive funds, and that’s what most people in reality do too. (Personal share ownership has been in decline for decades, even in the US, despite the odd blip like the privatisations of the 1980s and the Royal Mail IPO…)

    I actually think there’s more chance of being a skilled active stock picker in your spare bedroom who beats the market (heck, it’s what I do / try to do) than a DIY fund-of-fund manager who picks winning funds, but that’s for another article. But skilled is the operative word. Most people are dire investors, and I wouldn’t be surprised if they do even worse as stock pickers than as investors in active funds, though I’m not sure I’ve seen the stats.

    There’s a lot of delusion in play, too. For instance some stock pickers think they did very well beating the FTSE 100 with their small cap portfolios over the past 3-4 years (well, up until March 2014!) but their returns may not have held a candle to the likes of Aberforth Smaller Companies Trust or the Rights and Issues Trust. i.e. Better comparisons of small cap stock picking!

    @Edward — I wouldn’t agonize over it, presuming it’s a small part of your portfolio (e.g. 5% or less) and you’re attached to it. You could leave it be, and see what happens. On the other hand, if you really don’t believe in active fund management at all and this is just a legacy holding then maybe best shot of it, as presumably you wouldn’t buy it today (and therefore why care about the soft close?)

    Your choice of course! 🙂

  • 4 Edward October 17, 2014, 10:15 am

    @The Investor – right on both counts. It isn’t a huge proportion, and I wouldn’t buy it today. Probably I’ll just keep calm and carry on…

  • 5 Hannah October 17, 2014, 2:50 pm

    Ermine, you sound like a market timer, if you’re interested in choosing the right time or the wrong time to buyand sell shares. I prefer setting an allocation, and sticking to it. That way, I never have to speculate, allowing me to invest and rebalance as dispassionately as possible. It has allowed me to do much better than most people (dare I say more than 95% of investors?) during my past 25 years of investing.

  • 6 magneto October 17, 2014, 4:45 pm

    @Hannah
    Regret I have been investing even longer than your goodself !
    and made plenty of mistakes.
    However if I have learned anything over many market cycles, it is that valuations do matter !
    This can be considered simply a risk control approach, with any outperformance simply a bonus.
    Are stocks equally risky (downside risk) when priced at either a PE of 8 or 32 ?
    Would emphasise we are not talking market timing here, merely a pre-determind plan as to what the stock allocation % should be at specific market valuations.
    The fixed % allocation is a good default method, and very popular, but in retirement the sequence of returns becomes critical, hence the more defensive allocation as valuations rise.

  • 7 Hannah October 17, 2014, 5:26 pm

    magneto,

    Even John Bogle says he doesn’t know anyone who even knows anyone who has times the market consistently. I don’t know, but maybe he has been investing longer than you and might have more insight.

  • 8 Jon October 17, 2014, 7:43 pm

    @TI, I consider myself semi passive becuse of a buy and forget equally weighted HYP – I wanted to ask, I have not seen an update on your HYP for a while ?

  • 9 The Investor October 17, 2014, 9:31 pm

    @All — Just read an interesting article on how new funds are modestly worse than average, which backs up my ‘avoid ’em’ suggestion.

    @Jon — Yeah, I forgot to update it in May, so I’m probably going to just wait until next year now. Someone asked about it on that page, and at the time it was lagging the market. Might be better or worse now. We’ll see in 2015! It’s been somewhat scuppered by Tesco and BBY. (Note: It’s nothing like my own personal portfolio, it’s just a small real money demo I run with c.£5K in it).

  • 10 dearieme October 17, 2014, 10:21 pm

    I’m not clear why beating, or matching, the market is a natural goal for every investor. Why shouldn’t I be happy to get returns lower than the market’s, but with lower levels of risk? Moreover, I don’t much like the equating of risk to volatility – it sounds more like a convenient mathematical simplification than a serious attempt to model performance features that might appeal to different real investors.

    The performance I really want is one that hedges the risk of our Final Salary pension scheme falling into the hands of the PPF, and thereby losing almost all of its inflation-protection. That matters more to us than chatter about volatility and growth. Even worse, if the FS scheme to which we both belong gets into trouble, it’s quite big enough to plunge the PPF into trouble too. Oo Matron!

  • 11 The Investor October 18, 2014, 8:03 am

    I’m not clear why beating, or matching, the market is a natural goal for every investor.

    @dearieme — Agreed, I don’t think it is (or should be) the goal of many investors at all, but that’s a different question really to the active/passive one. The most efficient way to reduce risk by accepting lower returns is to hold fewer equities and make up the difference with bonds and cash, not to pay somebody to try to choose less risky equities.

    Did you ever see this reply I wrote to you a few months ago, incidentally? Same vein.

    I agree with you about risk. 🙂

    That matters more to us than chatter about volatility and growth.

    Fair enough but it’s not the same for everyone.

  • 12 rajkanwar October 18, 2014, 8:59 am

    I have to agree with @ermine that market timing does matter.

    However, it matters less if you are saving a set amount every month. This rides out the irrational fluctuations in the market over long term.

    That said if you come to your retirement time and it happened to be 2009 would you not be better off not cashing out and letting market go into up cycle or at least moderate?

    Investing is active funds is zero sum game that is given. But to me also it is given that market goes through boom and bust and one needs to be aware of and guided by it.

    That said it does require one to do a bit of research and have understanding of financials to work it out.

    For people with non-financial background dripping in and dripping out might be the best way to avoid market timings issues.

  • 13 The Investor October 18, 2014, 10:23 am

    @rajkanwar — The issue is whether you try to use timing and valuations, or whether you enable your asset allocations – which should change with age – to take the strain.

    Most people following a traditional asset allocation path towards retirement should be automatically holding fewer equities as they approach retirement.

    I agree sequence of returns risk is an issue – and the truth is I do keep an eye on market valuation (not absolute levels, of course) – but I am certain most people will do much worse trying to time their way in and out of markets.

    Amongst much else, seven years of reading half-baked and wholly inaccurate predictions about the direction of various markets in the comments of this very website has demonstrated that to me in abundance. 🙂

  • 14 magneto October 18, 2014, 11:00 am

    One of the best and simplest views of sequence of returns risk, was in another thread :-
    “If an 85 year old losses 20+% of his portfolio value, he may have a 5 year problem on his hand. On the other hand, if a 65 year old loses 20+% of his portfolio, he likely has a 25 year problem on his hand, assuming he & his wife live to age 90.”

  • 15 rajkanwarbatra October 18, 2014, 12:30 pm

    @The Investor I agree with you there. Any smart retirement portfolio
    should derisk with time.

  • 16 dearieme October 18, 2014, 1:14 pm

    “Did you ever see this reply ?”: I hadn’t; thank you for it. I’m not bemoaning our fate – it’s more a case of worrying what might go wrong. With our DB pension scheme I feel it’s wonderful as long as it outlasts me and my widow. But golly it’s a big, concentrated punt.

    As for derisking by buying sovereign debt – hm! Now, OK, perhaps. In a year or two’s time – maybe not.

    I dare say it’ll be passive investing in equities for us, after I’ve fretted around the track a few times more.

  • 17 The Rhino October 20, 2014, 5:31 pm

    @ermine can you remind me of those russia funds/etfs/ITs you dug out (you did tell me in a prev post but i can’t find it for love nor money)

    i was thinking of taking a cheeky punt on this one, db x-trackers MSCI Russia Capped Index UCITS ETF 1C (GBP), ISIN
    LU0322252502

    am i right in thinking the terms ‘capitalizing’ and ‘distributing’ in relation to etfs are the equivalent of ‘acc’ and ‘inc’ respectively in relation to funds?

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