Deciding between actively managed mutual funds and passive index funds
We have been told by the high priests of finance about the importance of investing of future and not saving only, so as to beat inflation. We are also told that even professionals find it tough to time the market, let alone ordinary people like you and I. Put out any charts for the past 40 years for returns on various assets classes, chances are equities brings the highest return over a 40 years period of all assets classes. The conclusion is that we should invest in some actively managed mutual funds/unit trusts with high transaction fees, high load fees and high expenses ratio etc, and let our money managed by so called professional fund managers for greater returns than the markets.
Warren Buffett’s million dollar charity bet
During the year 2008, Warren Buffett famously made a million-dollar bet with a fund that consisted of hedge funds, net of fees, an S&P500 index fund will beat the expensive hedge fund over the next 10 years. The winner can decide which charity the one million dollars will be donated to.
It is a well known fact that the sage of Omaha once rejected a $2 bet in a golf course when the odds are not in his flavor, what caused him to have such a high conviction that most actively managed mutual funds, not only hedge funds will do worse than the markets in the long run like 10 years?
Bill Sharpe, a Nobel laureate, wrote a very common sense paper in 1991 that the average dollar invested in the stock market from all the investors will equal the market’s return minus expenses. This is a simple mathematical fact, the conclusion that the market must equal itself. Think about it, if MacDonald is still there 10 years later, any exchanges of its shares among investors during these 10 years will not and does not affect the underlying economic profits of its businesses. The price of Macdonald’s stock 10 years later depends on what investors are willing to pay for it 10 years later regardless of how many exchanges done between investors themselves during these 10 years – the market must equal itself.
In almost every marketing message of actively managed mutual funds, there is always this message of “long term investing”, however, this is not always what the fund does in reality. The fact is that if the fund will to do better than the market, the fund managers cannot simply buy and hold, in doing this, the funds will most probably achieve market returns, and then you don’t really need their expensive services. You can buy and hold on your own. As a result, they need to constantly trade securities. However, this will increase transactions costs, though their costs of buy and selling stocks are less than what we paid through brokers. This results in turnover of more than 100% in any one year when they tell you about the benefits of “long term investing.”
But how can your fund manager beat the market when fellow fund managers are also as smart as your guy?
The conclusion is that the reality of the funds contradicts their marketing messages of “long term investing.” And when you trade too much, you are subjecting yourself to Newton’s fourth law of motion, which states that returns decreases as motion increases. (Be it an average person or a fund manger with state of the art software and Bloomberg terminals)
Next look at all the costs associated with an actively managed mutual fund, initial fees, management fees, expense ratios, A much higher return is required to be generated by fund managers given that after paying so much costs, I think one cannot expect just a positive return that is around the same as bank fixed deposits, nor even market returns (as you may as well invest in index funds).
The problem is that actively managed mutual funds need to generate a 50% more return than the market just to give a decent return, as need to deduct all the initial and ongoing costs. For example, if only got 10% return, net of costs, most probably the return is less than market, though still a positive return. Anything less than maybe 6% return of the fund means that you have made a lost investing in it.
Any return less than that means that one will be better of investing in passively managed index funds.
You can look at historical returns of some mutual funds/unit trusts in Singapore and United States to justify what I said.
Of course, this is inconclusive that every active managed and high cost mutual funds will do worse than the market but the odds are there given the causations and what history tells us.
Assume the following for a fair comparison,
1. Using a holding period of 5 years
2. The mutual fund/unit trust has an initial charge of 6% and annual fees of 1.5%.
As you can see, the professional fund manager needs to achieve average return for these 5 years of 7.5% to match market’s return or investor’s return of 5%, which is around 50% better.
What are the odds of that, coupled with all that I mentioned?
In the next post, I will further elaborate on market cycle investing using index funds rather than buy and hold until cash out 40 years later. This will significantly increase returns than just simply buy and hold index funds.
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