The Case for Actively Managed Funds

To begin let me say that I am a regular reader of the Wall Street Journal and have great respect for the quality of their journalism. Last Monday I was scanning the “Journal Report” when I noticed an article entitled
“The Case for Actively Managed Funds”,

After reading the article I couldn’t help but to think that there was a lot wrong with it. Mainly it was based on a premise that professional money managers have some magic power to predict the future or that they know something that thousands of other highly-skilled money managers don’t. In essence the article makes a questionable case that active managers have the ability to add value by outperforming a benchmark like the S&P 500. My problem with the article is that the author time and again suggests that in order to do this, the manager can predict future prices and/or gain an advantage of information that so many other skilled managers don’t have access too. To be fair to the authors premise, each year there will be instances where this is true, but we should look at the facts as opposed to an unfounded opinion.

Fact #1 is that when these magical managers do in fact outperform some appropriate index it is short lived at best. It is a well-documented fact that over the long term 80 percent of active managers fail to beat their benchmark and in fact get beat by the market!

Fact #2 – there is no way of reliably predicting in advance which managers are going to outperform in the short run! This kind of article is just another example of where the media aids the Wall Street machine in keeping you confused, and in that confusion the money continues to move, transactions happen based on greed, fear, and confusion, and Wall St. continues to prosper at your expense.

The key question, whose answer can literally save you thousands of dollars annually, is why do so many highly-skilled managers fail to outperform their appropriate benchmark over time, and in fact are getting beat by the market? While there are several reasons for this we’re going to focus on one – unnecessary costs and how those costs make it highly improbable that an active manager can in fact beat the market over time.

A typical active manager charges around 1.2 percent annually (operating expenses and management fees). Let’s further assume that because the manager is trying to guess will stock A do better than stock B this year they are trading regularly (this is referred to as turnover in the investment advisory world). And for simplicity sake let’s just say the turnover by the typical manager in any given year is around 100 percent . That turnover costs money in trading costs and commissions that don’t show up in any prospectus or marketing literature. And I have read several papers and studies that put the price of that turnover between an additional 1 – 2 percent annually. So if we go with the lower additional cost for turnover, the typical active manager has to do better than the market by 2.2 percent (1.2 percent management fee + 1 percent turnover costs) annually to beat the market. In other words it has to do 2.2 percent better than the market consistently over time, and how likely do you think that is? And that is to say nothing of risk, taxes, commissions and fees generated at the individual investor level, or the anxiety caused by chasing performance! So in closing I will leave you with two thoughts; 1- Investors will be better served by constructing their portfolios with reputable passively managed investments. This one strategy alone will reduce your costs from 2.2 percent annually to .30 percent annually (on average). What does this mean to someone with a $500,000 portfolio? It means the difference between paying $11,000 annually vs. $1,500 annually in expenses and trading costs.

My last thought is to follow our investor education piece in this blog, “12 Steps to Becoming a Great Investor,” where we will continue to explore and discuss themes such as this that give you every opportunity to do better!

s. joseph disalvo

S. Joseph DiSalvo, ChFC, President of Quest Capital & Risk Management, LLC, has more than 15 years of experience in the financial services industry. He is passionate about helping clients build successful Financial Life Plans to align with their deeply held values and life aspirations. He founded Quest Capital & Risk Management in 1997 to create a unique business model that looks beyond a personal financial statement to help clients build their best life plan. Visit us at: