Published: Mon 17th July 2017
Read Time: 5 minutes
Sack Mutual Fund Managers?
If you really look at the statistics, it seems ludicrous to hand over your money in fees to actively managed funds when there are many other passive alternatives. You have the choice between paying 1.4% in fees to line the pockets of fund managers or pay a mere 0.25% in fees for a generally similar or even better performance delivered by a passive fund.
Going back to the basics of investing, all investors are advised to diversify and purchase a variety of different types of securities to hold over the long run. All mutual funds provide investors with a diverse basket of securities, and it is down to the fund management team to make the decisions as to which securities to purchase to set up the fund. The performance of the fund is then tracked and the value of the fund is compared to a benchmark. There are many different benchmarks in each sector, and these benchmarks are a basket of securities usually weighted around different companies and their market capitalization in the sector. However, it is now clear that most of these actively managed funds consistently fail to outperform the benchmark.
The bar chart shown indicates that 88.30% of large cap mutual funds underperform the S&P 500 - the benchmark in this case. It is very unlikely that the funds that outperform the benchmark will continue to do so consistently year on year. As investors hold positions for long periods of time, this becomes a problem.
The Problem with Active Investment Strategies
The efficient market hypothesis (EMH) states that it is impossible to beat the market due to the stock market being efficient. This means that it incorporates all relevant information into the share price and consequently it would make it impossible for active managers and other investors to pick “undervalued” shares. If this hypothesis was to hold true, then it means that active fund managers have little to no advantage over passive funds in the long run. In the short run, the fund managers may get lucky with their choice of stocks and see an initial rise. The rise of technology and the ease of access to information seems to suggest that the EMH may be true, despite continuing unsettled debate. Information circulates very quickly and with electronic trading it could be argued that our markets are becoming more efficient. Despite this, there is the issue of obtaining some information and acting on it properly meaning that there is potential for active management to beat the market, however it is becoming more unlikely.
As these mutual funds vary so much in annual performance, it becomes difficult as an individual investor to choose which fund to invest with. A simple solution would be to invest in all the securities in an index, or at least a representative sample. As a result, this means that investors should choose passive funds. These passive funds undertake little or no research and simply hold a stake in each company in the index. The funds rebalance themselves throughout the year as the market capitalization of the companies in the index varies. As a result, these funds have significantly lower fees which helps to further boost investment returns.
The real question is why do these passive funds seem to outperform active funds? If we look at performance, it appears that often an increase in the overall value of a fund is due to one or two equities outperforming the others. If you have a passive fund (which is invested in the whole index) you will be exposed to this increase in value. If you have an active fund, you will be only exposed to this increase in value if the fund manager deemed the equity to be a “winner” and consequently chose to invest in it. It seems that investing in the “winners” is not a simple process, despite the barrage of research undertaken by the team of active fund managers.
Vanguard brought the first passively managed fund to individual investors in 1976 and the industry is now becoming increasingly popular with a large amount of investments now in passive/index funds. In addition to this, ETFs (Exchange Traded Funds), which operate in a similar way are increasing in popularity. There are currently concerns that if all investors switch to passive funds then the fluctuations in the stock market may become exaggerated. However, there is little evidence showing that this is the case.
Will Mutual Funds Vanish?
Although it looks like the actively managed portion of the market will continue to shrink, it still represents a very large proportion of the market. This means that actively managed funds will not be disappearing anytime soon. However, the decline in the number of investors choosing actively managed funds may cause changes in the industry. For example, fund managers that do survive and outperform the market may spend large amounts of money on aggressive advertising techniques to promote their investment strategy and the fee structuring of these actively managed open ended funds may change.
In the future, more investors may opt to invest in closed-ended investment companies such as investment trusts. These investment trusts are floated on the stock market and investors can buy and sell shares of these companies. These companies have the advantage of lower fees than open-ended funds and generally they have seemed to outperform benchmarks. These investment bodies could be another alternative to actively managed open-ended funds.