Why Actively Managed Funds Fail to Beat the Market

There was recently a question in the Facebook group about whether a mutual fund offered at one of the banks was a good thing to have in their RRSP. She mentioned that the management expense ratio was 2.04%.

A quick aside. Management expense ratio (MER) is the percentage that will be deducted from your returns to cover administrative, management and marketing costs for the company. So if your MER is 1% and at the end of the year, your portfolio is worth $1000, the company will automatically take 1% ($10), and give you $990.

Of course, I didn’t know anything about this fund. And in my response to her, I said that my gut feeling was that it was some sort of actively managed fund. Why else would they charge something so high. And if it were, I would have many issues with it and would write all about it here.

1. Why A huge portion of actively managed funds fail to beat the market over time

Flatout, most important part. Why would you pay someone any sort of money to do worse than what you could simply do by purchasing an index fund.

But don’t let me talk about it. Let’s use Warren Buffet’s exact words in his 2017 newsletter to shareholder:

“In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund.

Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?

What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.

[…] The compounded annual increase to date for the index fund is 7.1% […] In it, the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000”

There are a couple of things that stood out to me. The first one is that, I too, like Warren Buffet, would have expected many more professional investment managers to have taken him up on the bet. After all, we’re now talking about the top of the tops in the world of active managers. The people that only work with billionaires and pension funds, and not people like us. To only have one who was willing to step up is a big red flag in my eyes.

Secondly, wow… 2.2% vs 7.1%? I mean, I believe that the majority of active will do worse than an index fund, but I did not expect it to be that staggering. But then again, it’s not completely fair to average the 5 different funds that the person chose. So I broke it out.
Fund A’s compounded average growth rate is 0.9%.
Fund B 2.8%
Fund C 5.6%
Fund D 0.3%
Fund E 0.8%
Index Fund 7.1%

Now I can say wow…

Why the fund that you’re being sold might look like it’s got a chance to beat the market

Another big problem with actively managed funds is something called the survivorship bias. It happens all the time. You hear about the kid who drops out of university and starts a company. The next thing you know, it’s worth billions. Or the company of 20 that gets sold to facebook for billions (ie instagram).

What you don’t hear about is the other 99 kids who drop out of university to start a company, and fails. And has to go back to school. Or has to find a way to pay back all the debt they took out for the company.

After all, we all want to be sold on a future with rainbows and unicorns.

And this is exactly the same thing that’s happening with what you’re being sold to.

So how does it work? Well, I don’t know all the rules and regulations, but this is what I’d do to create something that seems better than the index. I’d play with hundreds, or thousands of asset allocations and chart their returns over the past 10 years (in other words, I’m taking historical information). The ones that did better than the index, I’ll keep and sell that to you saying if you invested in this portfolio 10 years ago (even though it technically didn’t exist), you’d make this much. I’d then charge you a pretty penny. Or a pretty nickel for you to invest in it.

Problem there? I threw out hundreds, thousands, even tens of thousand other allocations that failed.

Of course, that’s an extreme example. I’m assuming that there are more rules in place than that. So the next alternative is to give all these “investment gurus” who work for me some money to create their own funds. After 10 years, I’ll see which ones did the best, and promote the person to become the lead investment guru for the fund and put lots of marketing dollars to promote people to invest.

Once again, survivorship bias.

The other problem? Will this person continue to perform at that level the next 10 years? Will this person leave after 5 years to work for more pay and will the person who replaces this person be able to continue to perform at that level?

Probably not.

The ones who’ve proven to beat the market over time aren’t available

Tony Robbins wrote a book called Money, Master the Game (Goodreads, Amazon) – a book I highly recommend everyone read as he breaks it down to the simplest of terms. In it, he interviewed 50 of the top investment managers in the US. All of them are not willing to take more money to be invested. Why is that?

Let’s use a simple example. If you had $100 and had to grow it by 20% in one year, how would you do it? Well, you could spend your time on kijiji, and find some vintage item being under priced. You then buy it, and sell it at a 20% markup. Poof, 20% return that year.

Now if you had $100,000 and had to grow it by 20% in one year, what could you do? Could you continue to use the kijiji idea and make $20 1000 times to make it happen? Possibly. But you’re more likely to move up to more expensive things. Say you… boy I’m having a hard time coming up with something here… okay, say you buy a house (mortgage it, so let’s say it’s worth $400,000). You then create the basement into a second residence with your own hands, so that your total cost is $100,000. You then sell the house for $420,000, and make $20,000 – a 20% return.

So what about $100,000,000? What would you do? If it were Warren Buffet, he’d buy companies that are underpriced, and fix them up.

And there lies the problem. The true investment gurus can provide returns in the double digits each year for decades will essentially have an unlimited amount of money trying to invest with them. Each time they take more, they will find it that much harder to continue to perform at that level. So they stop taking money.

So do individuals like us ever stand a chance of getting in? No. The best way I can think of is to buy shares of Berkshire Hathaway. It only costs $250,000 USD. The nice thing? It’s proven to return a compounded average growth rate of 20.8% (almost 3x better than the stock market).

So once again, will the person you’re investing your money with be able to beat the market for the next decade or two? Probably not.

The real damage behind management fees

Let’s say you put in $5000 a year into your retirement. It’s invested in some sort of actively managed fund, and they charge you 2.04% in management fees. We’ll keep this example super simple and say this fund somehow returns you 5.04% each year before fees. After fees, you get a return of 3%. You do this as soon as you get your first job when you’re 22, and you’ll stop once you hit retirement at 67 – 45 years later.

So what is your portfolio worth then? $463,599.31.

Now, let’s say your management fees goes from 2.04% to 1.04%, a one percentage point drop. Now your return is 4%. What is it worth 45 years later? Is it a few thousand more? Tens of thousands? Well, it’s now going to be worth $605,146.96. $140,000 more.

Now let’s say you’re able to drop the fees down to .30%. The value now? $742,244.26. Another $140,000 more.

In other words, we’ve gone from a portfolio value of $464,000 to $742,000. An increase of $280,000.

So not only are you getting worse returns, but you’re also paying a lot out of your future retirement for these meagre returns.

Chart showing your return over time assuming you put in $5000 at the end of each year and you constantly achieve a 5% return
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What are your alternatives

By now, if you are interested in anything like this, you are either super upset at all the poor performances that you have gone through, or you are super happy to be reading this and ready to make the future a little brighter. Or both. I hope it’s both

So if you do want to stop with what you have, what should you be doing instead? The first step is to open your own discount brokerage account. Don’t worry, you’re not going to be actively trading or anything like that. You just need a way to buy index funds or exchange traded funds (ETFs).

A quick aside: an exchange-traded fund is an investment fund that gets traded like a stock. That means you can buy or sell it with relative ease. The nice things about ETFs are that the majority of them track some sort of index which means that you won’t have to buy into the index fund itself, but can buy an ETF that replicates it. ETFs also have management expense ratios, but the best ones (from Vanguard are all sub 0.50%, with many of them hovering 0.20% and a few of the key ones under 0.10%.

So if you currently have a trading account with a bank, I suggest cancelling them and using Questrade. Once again, like most other things at a bank, you are overpaying significantly to use their services. For example, with TD, you are paying $10 to place a trade, while it would be $5 at Questrade. Except there’s one caveat with Questrade. If you are buying some sort of ETF, they will not charge you any commissions. That means even if you wanted to buy one share of an ETF, it’d be completely free!

This is even more important when it comes to having a self-directed RRSP account. TD will charge you a $25 “maintenance fee” each quarter if you do not spend more than that in commissions during that quarter. Seeing as our goal is to buy index funds, or ETFs that track index funds, it seems like this will be a common fee. Of course, if you do have over $15,000 in the account, they will waive the fee. Questrade on the other hand, has no such thing as a maintenance fee.

So if Questrade sounds like a good idea for you, open an account through this link and they will give you up to $250 for signing up.

Now what

So you have some sort of discount brokerage account to make your own trades. Now what? What should you buy?

I don’t know. I’m not you, I don’t know your goals, knowledge or risk tolerances. However, there are two things I can suggest.

The first one is taking Warren Buffetts’ advice and investing in the stock index. I would suggest using Vanguard’s ETFs as they have the lowest management expense ratios out there. They are also the most popular company to go through. If you are interested in the Canadian index, the ETF you would want to look at is VCE. If you are interested in the US index (which is also the one that Warren is talking about in his newsletter to shareholders), you want to look at VFV.

But before you go down that path, you need to understand something. Yes, over the course of time, these indexes will outperform the majority of the actively traded funds out there, but that doesn’t mean that it won’t go through rough periods like in the 08-09 crash. The indexes at that time went down 50% (along with most other companies). I don’t know if you will experience another 50%+ crash, but there will be multiple 20% crashes throughout your life. They will most likely be followed by 30% recoveries right after, leaving you okay over the long run. But you will have to be able to stomach having faith that it will work out. It’s easy to say or think that now, but when it happens, you’ll be on your own.

I’m not trying to scare you. I don’t know if I truly understand the situation myself (I only turned legal to invest when the 08-09 crash was close to the bottom). But this is something that we both need to understand.

Do you want to be a couch potato?

Of course, there are other investing philosophies that can reduce the risk of major drops. But they require you to go out there (on google) and find your own answers.

A good place to start is a website called Canadian Couch Potato. The person who runs it is a firm believer in passive investing and does a lot of research into different passive investing methodologies. A great place to learn about the different methodologies, and finding the one that works best for your goals. He’s also quite respected in the personal finance community.

Oh, and if you do go down this path, could you please share what you’ve learned in the comments below, or better yet, in the facebook group and leave a hashtag #ccp for others to be able to find it in the future.

Still too daunting? Robo Advisors might be for you

I’m not going to go too deep in this topic. I’ll save that for another post. However, robo advisors are like your traditional investment advisor except they tend to invest in index funds, making it passive, and thus, much cheaper for you.

To learn more about robo advisors, I suggest going to MoneySense.

Or go for the massive returns that outperform the stock index 2-3x annually

Of course, there’s a caveat: you’ll need to have a quarter of a million dollars. Did I mention that’s a quarter of a million US? But let’s say you do. What exactly am I talking about? Investing directly in Warren Buffet’s company, Berkshire Hathaway.

Berkshire has a compounded annual return of 20.8% since it opened shop in 1965. That’s easily 2-3x more than the stock index. But their shares are around $250,000 each, making it quite difficult to buy. And if you do, there’s no way to sell a portion of one. It means you will literally have to be in it for the long, long run.

But 20.8% return is pretty nice, no?

Conclusion (ie TL;DR)

For the everyday person, we will be much better off investing in multiple index funds than have someone actively manage our investments for the following reasons:

  1. A huge portion of actively managed funds fail to beat the market over time. Warren Buffett even threw out a challenge to all the active investment managers out there. He expected dozens to take him on the challenge. Only one did. The person chose 5 funds that will out-perform the market. After 9 years, the best fund gave a compounded return of 5.6%. The worse: 0.3%. The average: 2.2%. The index? 7.1%. This included the major drop in the stock market in 08-09.
  2. Companies spend a lot of money marketing the funds that seem to have done well in the past. Of course, they throw out the hundreds, if not thousands of funds that didn’t.
  3. Those who can beat the market, probably won’t be managing your fund for long. They will quickly rise to the top, where only institutions and billionaires can get access to it.
  4. Management fees can easily eat out $100,000’s worth of return over the years.

So what are your alternatives to having it actively invested? Go passive.

  1. Invest in the stock market index. As shown in the bet that Warren Buffet put out, the index can give you returns that most actively managed funds cannot. The risk in this is not going to be the index itself failing, but your emotions getting in the way when you see drops of 20%+.
  2. If that emotional rollercoaster is too much, look into Canadian Couch Potato for other passive investment methodologies that will help reduce the downside during those times.
  3. Or if you have a quarter of a million sitting around, invest in a Berkshire Hathaway stock. Afterall, they’ve shown a compounded annual return of 20% since inception, almost 3x better than the stock index.