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.
- Passive investing just feels wrong.
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?
“…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:
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.