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Are You Smarter than a 5th Grader? Not If You Invest in Mutual funds
The arithmetic of active investing
The paradox of investing is that to be a great investor means being average.
This sounds counterintuitive and is the opposite of what the financial services and financial media industries have trained us to believe. But it’s true; even the most brilliant investment managers on Wall Street can’t do better than average.
I’ll prove it using basic math concepts most of us learn by the 5th grade.
The arithmetic of active management
Over the past 15 years, 93.4% of actively managed investment funds in the U.S. underperformed the S&P 500 when investment fees were taken into account.
That should tell you all you need to know about the paradox of investing. The only reason someone would pay higher fees for an actively managed mutual fund — when they could stick their money in an index fund for next to nothing — is because they expect the fund manager to outperform the index.
Actively managed mutual funds try hard to deliver higher-than-average returns. They hire brilliant investment managers and an army of analysts who spend all day looking for investment opportunities to exploit. For all of their efforts and all their resources, they fail to beat boring old index funds the vast majority of the time.
Willam Sharpe explains why most active managers fail to deliver so-called “alpha” (higher risk-adjusted returns than the market) in his 1991 paper, “The Arithmetic of Active Management.”
As Sharpe says, the case for investing in actively managed mutual funds only makes sense if you are willing to suspend the laws of basic arithmetic.
Before we break down the grade-school math on why mutual funds are not a rational choice, here are a few basic facts you need to understand.
Actively managed funds have higher fees (often 1%-2% per year) than passively managed index funds (often below 0.1% per year.)
Remember, an index fund replicates the stock market. If Amazon is 4% of the S&P 500, it will make up 4% of an S&P 500 index fund.
So, an index fund will provide investors with the average market return minus its nominal fee.
Actively managed mutual funds pay a portfolio manager to make investment decisions. If the manager believes Amazon stock will fall, they will hold less Amazon stock than the index fund.
This quote from Sharpe is also critical to understand, so I will break it into two parts.
“Before costs, the return on the average actively managed dollar will be equal to the return on the average passively managed dollar.”
When you add up the returns of all of the actively managed investments in the stock market, you get, well, the stock market, so mathematically, it must be true that the average actively managed dollar is equal to the average market return before we account for investment fees.
“After costs, the return on the actively managed dollar will be less than the return on the passively managed dollar.”
Which is exactly what we see in the data; 93.4% of actively managed investment funds underperform the S&P 500 when accounting for investment fees.
If the average return between index funds and mutual funds are the same, but index funds have much lower fees, then the net return of index funds > actively managed mutual funds.
I can already hear the comments.
“Ben, you’re talking about the average mutual fund but I would never invest in an average mutual fund.”
Let’s dig a little deeper and understand why it’s so incredibly difficult to:
A.) Outperform the stock market consistently over a long period of time.
B.) Pick an investment manager that will consistently outperform before they actually do it.
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The crowding out of skilled active managers
A 2014 paper published in the Journal of Financial Economics explains in simple terms why it’s becoming increasingly difficult for any investment manager to outperform the market.
Put simply; there are too many skilled investors in the market today.
The bulk of stocks are owned by institutional investors, think Vanguard, BlackRock, pension funds, and endowments.
These institutions hire brilliant people to manage their portfolios. This means that Anytime a stock is bought or sold, there is a good chance that the person on either side of that trade is highly skilled.
Remember, when you buy a stock, it means someone else is selling it.
They are selling it because they have the opposite prediction about where the price of that stock is going. You are buying because you think the price is increasing, and the other person is selling because they believe the price is decreasing.
If the bulk of the stock market involved trades between amateurs, it would be much easier for skilled investment managers to find inefficiencies and generate alpha.
But when the Harvard endowment investment manager chooses to sell a stock to a hedge fund manager, these two managers are more equally matched. This means the more trades between skilled managers, the more even the split will be between who wins those trades.
As more and more money assets are controlled by large institutional investors who hire the most brilliant managers, there is paradoxically less chance that these brilliant managers can generate alpha because they are squaring off against equally brilliant managers.
To be fair, this study was completed before the rise of Robinhood and the meme stock craze, so there is probably more “dumb money” for professional investors to take advantage of in the past few years.
But I haven’t seen any data to indicate that active investors are performing any better than they have in the past. The fact is, the meme stock investors control a drop of water in the ocean that is the stock market.
Either way, the best you can reasonably expect from most active funds is to earn the average market return — before fees.
This leads us to the obvious conclusion that the most important investment factor in our control is investment fees.
Which is the real super-power of index funds; by their very nature, they will always have lower fees than active investment funds, and that tilts the odds of success in your favor.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.