Step 7: The Dirty Little Secret Of Managed Funds

Active fund managers get paid to beat the market. Funny thing, though, is that most fail. What is not funny …

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Active fund managers get paid to beat the market. Funny thing, though, is that most fail. What is not funny is why they fail.

Standard & Poor’s found that 77.4% of actively managed funds underperformed the S&P/ASX 200 index after fees for the five years ended 2014. Ouch.

But why do most active managers underperform? After all, they’re well trained and with Bloomberg terminals and swarms of research analysts at their disposal.

The most straight forward reason is many fund managers are closet indexers. No one gets fired for buying IBM (or BHP Billiton, or Woolworths), as the old saying goes, and there’s comfort in owning the same shares as your peers. Predictably, such unoriginal thinkers struggle to compete: Morningstar found that only 22% of close indexers outperform their benchmarks.

Managers also struggle to invest in the least picked-over part of the market: Small-caps. Like a whale in a bath tub, many managers have gathered too much money to deftly invest in small-caps. Their loss: S&P Capital IQ finds the median member of the S&P/ASX 100 is followed by almost 5 times as many analysts than the S&P/ASX Emerging Companies Index. When it comes to stock picking, it’s better to be a minnow than a whale.

This one will make you squirm: many managers don’t even invest in their own fund! A Morningstar study found that a staggering 45% of American equity fund managers had $0 of their own money in the funds they managed — not exactly a ringing endorsement.

Lo and behold, Morningstar also found that the average fund manager who has skin in the game outperformed the average one who does not, and that a manager’s odds of outperformance went up alongside the money they invested in their own fund.

The last reason is simple: Fees. Like most of us, active managers expect to get paid for their effort. However, like a midget running the 110 metre hurdles, funds with middling performance struggle to overcome their fees. Making matters worse is the high commissions funds end up paying to brokers when managers try (and usually fail) to day trade their way to success.

A Better Way

So the bad news is that most actively managed funds underperform. The good news is that investors can invert the problems above to increase their odds of outperformance.

  • Seek out managers with long track records of outperformance.
  • Tilt towards reasonable, aligned, straightforward fee structures.
  • Avoid closet indexers, who are basically charging an active fee for a passive strategy.
  • Look for managers with skin in the game — the more the better!
  • Low turnover, which means fewer commissions and is correlated to improved performance.

Meanwhile, you can always go in another direction…

The Humble Yet Extraordinarily Efficient Index Tracker

Welcome to “the index”.

An index tracker is a fund that copies one of the main stock market indices (like the S&P/ASX 200, for example) so that by buying into an index tracker, you can buy the overall market without having to pick individual shares.

The S&P/ASX 200 contains two hundred of the largest companies on the Australian share market, with each company weighted according to its market value. This means movements in large, usually more stable companies like BHP Billiton (ASX: BHP), Commonwealth Bank (ASX: CBA), Woolworths (ASX: WOW) and Telstra (ASX: TLS) affect the S&P/ASX 200 index much more than smaller companies.

Index investing is perfect for investors who just want the benefits of share ownership without either the hassle or the risks that are inherent in picking your own shares. Index investors won’t beat the market, but they’ll only underperform by a small amount (thanks to the — low — fees).

A good index tracker will cost you around 0.15% a year in fees — markedly cheaper than managed funds. Fees make a big difference. John Bogle, founder of Vanguard Investments, puts it this way

Over an investment lifetime, it turns out that the miracle of compounding returns is overwhelmed by the tyranny of compounding costs, and the investor ends up not with 100 percent of the market’s return but maybe as little as 25 or 30 percent, believe it or not, over 50 or 60 years.

Index Tracking Exchange Traded Funds (ETFs)

The best way for most investors to buy index tracking fund is right on the ASX, via something called an Exchange-Traded Fund (ETF). As ETFs are traded on the share market, you can buy and sell just as you would with a regular stock, using an online discount broker.

The Bottom Line: Buy The Haystack

The Motley Fool is all about encouraging you to take control of your own money and make better financial decisions.

The evidence is clear when it comes to investing in actively managed funds: Most underperform, and the average investor is better off placing their money into a low-cost index fund.

Then again, some managed funds do consistently outperform. And for some people, who don’t want to put in the time and effort of stock picking, those funds might be best. Or, if you’re Fools like us, you’ll now want to find some great individual shares to add to your stack. As well as potentially helping you beat the returns of the index, the holy grail of investing, it’s also fun.

Remember our Foolish motto?

Educate, Amuse, and Enrich.

Next -> Step 8. The Great Dividend Tax Advantage

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