In The Blogs

Chart of the Day: Active Mutual Funds Still Suck

| Tue Dec. 1, 2009 8:20 AM PST

You probably already know this, but here's yet another paper that demonstrates the foolishness of putting money into actively managed mutual funds. The authors used historical data and simulations to figure out if actively managed funds performed better than passive investments, and the chart on the right shows the answer: the blue line represents active funds and the red line represents the average distribution of passive investments. The zero point on the x-axis represents average performance.

Along the entire curve, the authors found that a higher percentage of funds performed worse than passive investments. For example, about 70% of active funds perform at zero or worse, compared to only 50% of passive invesetments. 90% perform under +1.0 compared to only 80% of passive investments.

If you drop out fees, active funds do slightly better: there are still more big losers than with passive investments but there are also a few more big winners. When you add in fees, though, this small effect is completely swamped and active funds are lousy investments all the way around. Don't waste your money.

Next up: could somebody please do with hedge funds? I suspect the results would be about the same. Via Felix Salmon.

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Kevin Drum is a political blogger for Mother Jones. For more of his stories, click here.

Comments

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It will be interesting to

Submitted by g. powell on Tue Dec. 1, 2009 8:33 AM PST.

It will be interesting to see what the consumer finance protection agency will have to say about this. A big, fat warning label on the front of every actively managed fund prospectus like those found on cigarette packs would be appropriate. But we all know that won't happen.

CFPA

Submitted by Mo (not verified) on Tue Dec. 1, 2009 3:11 PM PST.

Unfortunately, based on what I've heard, the CFPA is primarily focused on consumer debt (credit cards, mortgages), not protection for the retail investor. Regs relating to individual investors are being hammered out in the financial regulatory reform measures that are grinding through Congress. The SROs (Self Regulatory Agencies, i.e. FINRA) are using their vast financial resources in an attempt to control those of us who strive to minimize conflicts of interest when working with individual investors. If that doesn't succeed, they will water down the duty of care owed to a client so they can continue to push their high commission products.

As pointed out below, DFA is NOT an uninterested party in this study - since passive investing is what they sell.

Don't get me started on "past performance is no indication of future results" - how many glossy mutual fund adds have you seen with past performance numbers highlighted? (Maybe not recently, since the past performance numbers are pretty ugly after 2008.)

I Don't Trust Passive Funds

Submitted by Detroit Dan on Tue Dec. 1, 2009 8:34 AM PST.

Passive Funds = Index Funds. Correct?

Index funds generally buy more high priced stocks and fewer low priced stocks, because high priced stocks have a greater weight in the index. So it's a buy high, sell low scheme which doesn't seem too bright.

I'd much rather go with someone who actually looks at companies and tries to buy stocks that are undervalued. This is especially true in this day and age when the market has been seriously out of whack time and again. A passive stock fund would have been buying dot com companies like crazy as their valuations soared in the late 90s....

And here, in a nutshell, is

Submitted by MaynardHandley on Tue Dec. 1, 2009 11:55 AM PST.

And here, in a nutshell, is why active funds continue to make money.
Most people are like Detroit Dan. They view investing as a form of entertainment, NOT as a private necessary task, much like say, taking out the garbage.

Entertainment is about ups and downs, wild swings, cool stories you can tell your friends. Private serious investing is about making a little bit more steadily, every year, and what's the fun in telling your friends, after the crash of 2008 "well my portfolio is down a little, but only about 15%" or, in 1999 "sure it was a good year, I think I made about 7%"?

Eric Falkenberg has demonstrated, in excruciating detail, that extremely volatile assets (whether its sticks, long-duration bonds, or high budget movies) are priced way higher than theory says they should be, and than their long term returns justify. He attributes this to the fact that the bulk of people who claim to be investing are in fact supporting a very very expensive entertainment habit.

So go ahead, Detroit Dan, enjoy the highs and lows. In 30 years, when you are retired, you can be the Greg Dawson of 2039, complaining about all those moochers demanding high social security because they never saved for retirement. You, of course, did try to save, and you had a few successes, but then a run of bad luck that just wan't your fault --- who could have predicted that the market would fail, because it's not like it ever did that before?

Re:

Submitted by Cal (not verified) on Tue Dec. 1, 2009 12:29 PM PST.

@Detroit Dan: "Index funds generally buy more high priced stocks and fewer low priced stocks, because high priced stocks have a greater weight in the index. So it's a buy high, sell low scheme which doesn't seem too bright."

Interesting hypothesis. I don't have a clear view on this, but one could ask why exactly are those High priced stocks priced high? Why are the low priced stocks priced low? Also, aren't index funds holding stocks in proportion to the total size of the companies rather than the price of a single share? That is, even though Berkshire's share price is much higher than Microsoft's, since Microsoft is overall bigger, it will be a bigger proportion of index funds.

To consider this further, index funds are basically placing their trust in bigger companies (which have more established business, lower chances of shutting down, more diversified products sometimes, less dependent on sudden downturn in operating or venture capital), and investing in these companies in the ratio that all investors as a whole have sized them through their sum total investments.

Whether a particular active fund manager may or may not beat this strategy is not knowable beforehand, but this certainly doesn't seem like a simple buy high sell low strategy.

"A big, fat warning label on

Submitted by MacGruber on Tue Dec. 1, 2009 8:41 AM PST.

"A big, fat warning label on the front of every actively managed fund prospectus like those found on cigarette packs would be appropriate. But we all know that won't happen."

All mutual funds caveat prospective buyers. Of course, the potential buyers actually have to read the prospectus.

Of course, this graph is quite broad and there are plenty of funds where actively managed funds do better than an index fund. My dividend fund has beat its Lipper average and almost every other benchmark, but I had to do the research to find it.

Most potential buyers, with enough homework, can figure out which funds perform best and put their money in those funds.

Expecting the government to do all the legwork for you is idiotic. If you can't do the homework when it comes to your own money, no government agency will ever be able to do it for you.

This is the finanical equivalent of making companies put "Caution: This Coffee is HOT!!" on their hot coffee cups.

I knew one of you

Submitted by g. powell on Tue Dec. 1, 2009 8:49 AM PST.

I knew one of you conservatives would bring that up.

But get real. Financial companies cover their asses with tons of small type that's written in language that most people don't understand. And we all lose when lots of ordinary people make stupid decisions. So you gotta spell it out in big block letters in simple words to help them understand what's going on. They need help.

I'm not a conservative, but

Submitted by Robert Boyd (not verified) on Tue Dec. 1, 2009 9:35 AM PST.

I'm not a conservative, but I think you are being unfair in this case. Literally every mutual fund (including index funds) is required to tell you that past performance is no guarantee of future results. Some version of that phrase is plastered all over their prospectuses, ads, etc.

By the way, Detroit Dan is semi-wrong. The portfolios of index funds are market weighted, which means they buy every company in a given index, but the ratio of ownership is based on the market capitalization of each company. So it's not the price of the stock that matters, but the market's valuation of the company.

But as you say, the market can value companies incorrectly--if it didn't, we would never have bubbles. So it's funny that Drum and Salmon are quoting a Fama & French paper, because Fama is basically the intellectual author of the efficient market hypothesis--the notion that the market is always pricing securities correctly (based on current information). And the host of the paper is Dimensional Fund Advisors, a well-known index fund. So they are hardly unbiased.

That said, it has been demonstrated repeatedly that mutual funds don't outperform the market on average. So if you can find an analyst who is brilliant at identifying underperforming stocks, go for it. Just don't expect his or her brilliance to last--it never does.

Yes, I'm fond of the phrase

Submitted by g. powell on Tue Dec. 1, 2009 9:40 AM PST.

Yes, I'm fond of the phrase that "past performance is no guarantee of future results" because the human brain is hardwired to think exactly the opposite. And combine that with greed, you get really stupid behavior. Therefore, I think harsher language is in order.

"By the way, Detroit Dan is semi-wrong."

Submitted by Detroit Dan on Tue Dec. 1, 2009 10:01 AM PST.

This is another way of saying, "By the way, Detroit Dan is semi-right." (c;

Seriously, I appreciate the clarification, and you (Robert Boyd) make a very good point about the connection between the efficient market hypothesis and the effectiveness of index funds.

Anyway, I guess I have to accept the facts as presented that mutual funds don't outperform the markets on average. Aside from fees, does that mean that individuals do a better job of picking stocks than do mutual fund managers?

I started moving out of mutual funds around 10 years ago, because the market was getting so overvalued...

semi-right

Submitted by RWB (not verified) on Tue Dec. 1, 2009 11:19 AM PST.

Yes, I should have said "semi-right"! You were basically correct, you just said it wrong.

Forbes

Submitted by Jon (not verified) on Tue Dec. 1, 2009 12:03 PM PST.

On the whole subject of active management vs. market indices, take a look at the latest Forbes investment guide. A year ago, they asked various financial gurus to pick one stock they would buy (and other gurus one stock they would short).

As a group, the long picks underformed the index. Now where's whats funny. The short picks also rose and outperformed the long picks (i.e. if you had shorted, you would have lost)!!

This is not true. Have you

Submitted by MaynardHandley on Tue Dec. 1, 2009 12:08 PM PST.

This is not true. Have you ever read the prospectus of a mutual fund company? They are well laid out, very clear, and make it quite explicit what is going on.

I hate the plutocracy as much as anyone, but I'm afraid that when it comes to investing, it is individuals that fsck up their lives, not companies. People who would research the purchase of their next stereo or car or video game console for weeks refuse to take a day to read an elementary book on personal finance, something like _The Only Investment Guide You'll Ever Need_. They refuse to engage in deferred gratification. They insist on seeing investment as an amusement, not as something involving real money. They continue to believe that, in a world where safe investments pay, say, 2%, the promise of 20% comes with little attached risk.

I don't want to embarrass you, g.powell, so don't feel you have to answer, but, seriously, considering you and your friends and family:
- how many take advantage of full advantage of their 401k opportunities? How many have read the prospectuses of the investment choices offered --- ACTUALLY READ THEM, they are not very long, as opposed to complaining how complicated they are?
- how many take advantage of the additional money that can be stuck in an IRA?
- how many have EVER read a book on personal finance?
- how many know the difference between taxation on cap gains as opposed to income?
- how many know what an EFT is?
- how many know the annual charge on their mutual fund assets, and how that compares to the lowest in the industry?
etc etc etc

Look, I am not a great fan on the US system. I think most people are too stupid and too weak to invest well, and that social security should do more for them, not less. But the system is what the people of the US have chosen, most of them claiming to be rugged individualists who want control of their lives; and the system is what we have to work with. Throwing out deliberate falsehoods about the opacity of most mutual fund prospectuses is not helpful.

Well, you're not

Submitted by g. powell on Tue Dec. 1, 2009 12:25 PM PST.

Well, you're not embarrassing me because you basically agree with me. Most people are not equipped to participate in financial investment, but we ask them to anyhow. The prospectuses are understandable to those who understand them (evidently), but as you point out, if you have never read a personal finance book, what do you understand?

Hell, forget about ETFs, I'd wager most people couldn't tell you the difference between a stock and a bond.

So you either hold their hands when they invest, or prohibit them from doing so all together. Since the latter is unlikely, I say do the former.

So what's wrong

Submitted by optical weenie on Tue Dec. 1, 2009 2:09 PM PST.

with expecting people to be sensible and read a book on personal finance?
Even Finance for Dummies is better than nothing.

Or is the excuse now that they are illiterate?

optical weenie lives in Oslo

Submitted by g. powell on Tue Dec. 1, 2009 6:09 PM PST.

I guess you could put a gun up to people's head and force them to read finance books, but I'm not sure that would even work. If you "expect people to be sensible", then I guess you live in Norway, not the U.S.

I mean, really, give me a break. We're going through a mortgage crisis where millions took out incredibly stupid-ass loans, and we all paid the price for their ignorance. These are the same idiots who re-elected Bush. And you're still expecting most Americans to behave like intelligent, informed financial consumers? If you want to learn more about America, you should come visit sometime.

I think the information is

Submitted by JBG724 (not verified) on Tue Dec. 1, 2009 9:22 AM PST.

I think the information is already there to see a fund's long term performance. That said, there have been some good articles on the hazards of chasing the latest hot funds. Fund (or fund company) gets big press, then money pours in, then performance tanks. The management fees create a potential conflict of interest for fund managers, where they are are tempted to take more money under management even if performance suffers (as opposed to closing to new investors). One answer is to look for funds that have a substantial portion of assets owned by the management team, so you know their interests are more closely aligned with investors (Longleaf is a good example of this).

Any prospectus will have a table showing the long term performance against the respective benchmark(s). If people can't compare these, then they should be in index funds. I think the answer is in better personal finance education at the high school level, not simplistic warning labels. Of course, better math education would have to go along with that...

Well, sure, in Cloud Coo-Coo

Submitted by g. powell on Tue Dec. 1, 2009 9:28 AM PST.

Well, sure, in Cloud Coo-Coo Land the math education is great and everyone reads the fine print before making major financial decisions. But on Earth things are a little different.

Charts and cat blogging -

Submitted by Anonymous (not verified) on Tue Dec. 1, 2009 9:26 AM PST.

Charts and cat blogging - two reasons I always read your site. Somehow when I see the charts, all the blathering falls away and the data talks rationally.

If I read the article correctly

Submitted by Greg in FL on Tue Dec. 1, 2009 9:28 AM PST.

(which is very possibly not true) the performance histograms of the active and passive aggregate portfolios are just the derivative (dy/dx) of these curves. The passive histogram looks to be very Gaussian, whereas the active histogram is more binomial, with a larger high-end tail, but with a median substantially below zero (which is the mean of the passive distribution). Hence the distillation that actively managed funds are very likely underperformers.

Passive returns being Gaussian is a bit of a surprise to me. Maybe it's because of the very large sample size. But it always seemed to me to be that returns had wider wings (buying Microsoft in 1980, or conversely Enron in 2000). But perhaps the extreme outliers are what people tend to fixate on.

Re Hedge Funds depends on what you define as hedge fund

Submitted by The Lounsbury (not verified) on Tue Dec. 1, 2009 10:29 AM PST.

Certainly for mutual funds investing in liquid equities or bonds, index (or flavours of index) is the way to go.

For non-liquid investments or investment in exotic assets (i.e. not plain vanilla equities or bonds), one does not have the same luxury of a frequently traded market wit

Now, as I know Drum does not actually know what a hedge fund is... although to throw a bone, the term is applied to all kinds of vehicles that are not in fact hedge funds in the classic sense, including the madness of hedge funds that essentially are mutual funds .

In any case, classic hedge funds played exotic ends of the market, in derivative plays etc. That is not something one can do via indices. Of course classic hedge funds were to hedge risk.

In any case, it is already well-known in financial research literature that a large number of funds started after the hedge funds craze began have performed very poorly.