The Basic Math Of Actively Managed Mutual Funds
Chapter 10 of The Rational Investor
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The paradoxical message of this book is that to be a great investor means being average.
In Chapter 9, we discussed the poor odds you’ll face if you decide to pick and choose individual stocks. But what if, instead of picking stocks yourself, you paid some high-powered mutual fund managers on Wall Street to pick stocks for you? Would you expect to outperform my boring portfolio of index funds?
No.
The reality is that even the most brilliant investment managers on Wall Street fail to beat the market consistently. Even if they do outperform the market, most (or all) of that outperformance tends to get eaten up by the high fees of actively managed funds.
I’ll prove it using basic math concepts most of us learn by the 5th grade.
The arithmetic of active management
At the time I write this, over the past 10-years, 83% of actively managed investment funds in the U.S underperformed the S&P 5001 when investment fees are 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 really 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 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 Management2.”
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.
Here are a few basic facts you need to understand before we break down the grade-school math on why mutual funds are not a rational choice.
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.
The following 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.
Here’s another quote from Sharpe.