Most Monevator readers know high costs are the major reason to avoid active funds, and that low costs are the biggest draw for index trackers.
However paying high fees to managers – as well as all the trading and other expenses racked up by an active fund – wouldn’t matter if they soundly beat the market.
Around here we tend to think of passive investing and index tracker funds as a ménage à deux, but there are plenty of people who invest in active funds who would describe themselves as ‘passive’ investors, too.
They simply put their money into a variety of actively managed funds, and then leave them to get on with trying to beat the market.
But sadly, the reality is few active funds do beat the market after costs, as explained in this Sensible Investing video:
It’s the failure of nearly all active funds to beat index trackers over the long-term that makes active versus passive such an unfair fight.
Imagine an alternate reality where, say, 40% of active funds beat the market.
Or maybe where 50% of funds beat the market – but with more volatility, or with fatter ‘tails’ that meant some active funds lost most of your money, but a good proportion spanked trackers.
Then we’d have a really interesting debate on our hands.
But as Jack Bogle, the father of index funds, says:
“The intellectual basis for indexing is is gross return minus cost equals net return. Period. What is the intellectual basis for active management? I’ve never heard one.
“Probably about 1% of managers can beat the market over the very long term.”
I wouldn’t call 1/100 anything but exceptionally long odds. Would you?
Are there any good reasons to invest in an active fund?
So as it is, there’s not really any reason to invest in active funds unless:
1) Your sister is a fund manager.
2) Your brother-in-law is a fund manager.
3) You like the romance and colour of active fund management, and you’re happy to pay for it and do worse overall.
4) You want to beat the market and you don’t care that the odds are hugely against you, and you don’t want to pick shares for yourself.
I paraphrase, but that’s the gist.
Now, occasionally a reader will voice a comment saying “it doesn’t have to be either/or”.
And I agree. (Heck, I pick shares for my sins so I can’t be precious).
However you have to be really clear about why you’re investing in active as well as tracker funds.
- If you want to juice up your returns, then investing passively in value and other so-called return premiums might do the trick.
- If you’re doing it to reduce volatility, then it’d almost certainly be safer and cheaper just to hold fewer equities and more cash and bonds.
- If you’re doing it to get overseas exposure, well, you can easily do that through ETFs and trackers.
- Some people claim they own active funds for the diversification, which makes little sense given the huge diversification offered by trackers – except to add the few hard-to-reach areas of the market like UK small caps.
Holding 10 active fund managers who invest in UK, US and European large caps is to my mind simply an expensive way of getting tracker-like performance at best, but doing worse after costs.
It doesn’t help that a growing share of active funds are closet trackers to start with.
How I’d invest in active funds
I believe the only reasons for investing in most active funds1 is either because you’ve a sentimental attachment to them (I’m not being facetious – many managers write great narratives about their ultimately fruitless decisions) or because you want to try to beat the market despite the poor chances.
If it’s the latter – and you don’t want to pick shares yourself, and return premiums don’t do it for you – then be smart about how attempt it.
How I’d probably try to go about it is to decide on my one or two very highest conviction active fund ideas (no mean feat, given academics have shown past performance is no clue to future performance) and then invest only in those one or two funds for my active allocation.
I’d then make up the bulk (say 80%) of my equity portfolio with tracker funds.
This way you get a little bit of active fund management colour if you want it, and if they beat the market then you will.
But most of your portfolio will remain pretty cheap, thanks to the trackers, and they’ll likely keep your returns in the same ballpark as the market, too.
Think of your modest allocation to active funds as an indulgence or a folly, like having a pot-bellied pig as a pet.
A bit of fun perhaps, but completely unnecessary, and probably more expensive than you think.
Check out the rest of the videos in this series so far.
- As opposed to active stockpicking, which is challenging and fun and my own foible. [↩]