The following is a 2002 editorial by our president, Susan Lee Miller. We thought our subscribers and website visitors would find it interesting, and useful to give to their friends who still insist on the virtues of active management...
Amid all the talk and reporting over the past year about Enron, WorldCom, and Wall Street analysts, one of the biggest financial scandals has gone almost unnoticed. By encouraging the use of actively managed mutual funds instead of index investments, the financial services industry is costing investors almost forty billion dollars each year in the United States alone. On a global scale, the cost is even higher.
To better understand this problem, think of a person sitting at the kitchen table trying to decide where to invest their retirement savings. He or she is faced with a mountain of advertising and marketing information about different mutual funds, much of which focuses on their respective investment objectives and historical returns. Some of them are index funds, whose objective is to match the average return for a given class of assets (for example, U.S. equities). Most of the funds on offer, however, are actively managed, which means that they attempt to deliver returns that are greater than their asset class average, through some combination of market timing (switching the fund's assets between equities and cash) and security selection (picking investments that will perform better than the asset class average).
To decide between investing in an actively managed fund or an index fund, our friend at the kitchen table has to ask herself two questions. First, how likely is it that the actively managed fund will outperform the index fund over the next ten or twenty years? Second, is it possible to identify future actively managed winners today?
Most studies that have examined the first question have found that very few actively managed funds outperform index funds over long periods of time. A study in 2000* looked at the causes of this underperformance. To active managers' credit, it found that on average, the stocks held by mutual funds outperformed the broad market index by about 1.3% per year between 1975 and 1994. However, the mutual funds themselves actually underperformed the broad market index by an average of 1.0% per year. What accounts for this 2.3% difference? First, the broad index, by definition, is always fully invested in stocks while mutual funds are not. This "cash drag" accounts for 0.7% of the funds' underperformance. The remaining 1.6% is due to the expenses charged to manage and market mutual funds, (1.0%) and transaction costs related to their buying and selling of shares (0.6%).
However, compared to the average mutual fund, index funds are much cheaper to run. The operating expenses charged by the largest equity index funds amount to around .20% of their assets, or .80% less than the average mutual fund. Index funds also have lower transaction costs, because they don't buy and sell shares as often as actively managed funds. In this case, the difference amounts to about .50% per year. At the end of August 2002, the market value of U.S. equity mutual funds was about 2.8 trillion dollars. The 1.3% difference in operating expenses and transaction costs therefore amounted to about 36 billion dollars per year. If this analysis isn't bleak enough, remember that it doesn't include the impact of front end sales loads (which are charged on many actively managed funds, but very few index funds) or taxes (actively managed funds typically generate higher taxable income for investors because they trade the assets they hold more frequently than index funds). In summary, investors in actively managed funds on average pay more and get lower long term returns than investors in index funds.
Active managers usually respond to this argument by pointing to those investment managers (for example, Peter Lynch or Warren Buffet) who have succeeded in delivering above average returns over long periods of time. Our response is to ask them how much they invested with these managers twenty years ago. This brings us to our second question: is it possible to identify future actively managed winners today? The great majority of evidence suggests that superior past performance does not persist into the future, which makes it extremely difficult, if not impossible, to pick future winners in advance. For example, we reviewed the performance of 446 actively managed U.S. equity mutual funds over the 1992-2001 period. We wanted to see if a fund's relative performance over the first five years of our sample could be used to predict its relative performance over the second five years. We found that only one fund whose performance was in the top ten percent of all actively managed U.S. funds over the first five years was also in the top ten percent during the second five years. Mutual fund prospectuses aren't kidding when they say that past performance is no guarantee of future success!
When you think about it, this really isn't a surprising result. To deliver above average performance, an active manager must have either information that isn't available to most investors, or a superior model for making sense of information that is widely known. In any given year, it is easy to see how this could happen. However, given the intensely competitive nature of the investment management business, maintaining these advantages over a long period is extremely difficult. Nevertheless, let's say it happens, and a manager delivers a few years of above average returns. What then? These days, the successful manager probably leaves the fund and goes off to run a private investment partnership (also known as a hedge fund) for far more money. But let's assume she stays with the mutual fund. As her success becomes well known, investors' funds pour in and the manager is faced with the challenge of profitably investing more and more money. She soon realizes that large investment opportunities offering above average returns are much harder to find than small ones. As a result, the return on the fund eventually falls back toward the market average (or below it). In short, successful past performance by an actively managed fund frequently brings about its own demise.
Nevertheless, despite the overwhelming evidence to the contrary, people still invest much more money in actively managed mutual funds than they do in index funds. Why does this happen? Three possible explanations come to mind. The first is that people are acting rationally: given their low levels of savings relative to their retirement income goals, they have no choice but to "swing for the fences" and hope that the active manager they entrust with their funds is the next Warren Buffet. The second explanation is that investors aren't acting rationally at all, and invest in active funds because they are overconfident about their ability to identify managers who will outperform the market average over the long term. The third explanation is that investors' "financial advisors" are leading them astray, perhaps because actively managed funds generate much higher sales commissions than index funds.
A recent review by the U.K. Treasury** made this case quite well. It found "a surprising predominance of active management, notably among advised sales [to individuals], where they comprise ninety seven percent of the total. The contrast with the institutional world is striking: in the UK, around seventy five percent of institutional funds under management are actively managed [the rest are indexed], while in the US it is only sixty percent. This discrepancy is hard to justify, given that institutional investors typically have much greater resources and expertise in the form of professional staff and dedicated investment consultants to devote to identifying superior active managers." In a great bit of British understatement, the report concluded that "it would be implausible to attribute this preference for active management, which is materially greater than that demonstrated by institutional investors, to superior expertise on the part of advisers to individual investors."
Whatever the cause of investors' behavior, their heavy use of actively managed mutual funds imposes a large cost on the economy. Apart from the annual transfer of wealth from individual savers to active managers, we fear that actively managed funds' relatively poor investment results will eventually lead to calls for higher Social Security benefits rather than income reductions by disappointed Baby Boomer retirees. Unfortunately, all of us will be called upon to pay the higher taxes this will require. This brings us to the question of why so few people up to now have called attention to this scandal. Cynically, one might think that few publications wanted to offend their big advertisers from the financial services. Alternatively, one could say that the euphoria of the bubble years made people less sensitive to the fact that they were vastly overpaying for the average returns being earned by actively managed mutual funds. Whatever the reason, it is now time for this scandal to get the full attention it deserves.
*"Mutual Fund Performance: An Empirical Decomposition into Stockpicking Talent, Style, Transaction Costs, and Expenses", by Russ Wermers. Journal of Finance, August, 2000.
**The Sandler Review of Medium and Long Term Retail Savings in the UK. Published by HM Treasury in July, 2002.
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