What if I told you that I am a world-class coffee brewer and my coffee tastes wonderful, better than all my competitors. Since my coffee is so amazing I command a premium of over 17 times the national average price of $1.38 for a medium cup of coffee. I charge between $24.00 and $34.00 per cup depending on the flavor. That’s how freaking good my coffee is!
However, Here’s the embedded risk that you won’t know unless your read my product offering memorandum:
- If I am able to pick the right coffee beans, at the right time and brew them correctly, then you will likely have above-average coffee for long periods of time.
- I can’t guarantee my coffee will be “the best” all the time, in fact my coffee could taste far worse than the average cup of coffee on any given day. Although, I believe it to be unlikely.
- There is upwards of a 50% chance my coffee will taste the same or worse that the average cup of coffee.
Knowing what I just told you, would you pay $24.00+ for a cup of my “maybe it will be great, maybe not” coffee?
Well Ladies and gentlemen: Welcome to the asset management business!
Please come and purchase my active mutual fund (i.e. premium coffee), but here’s what you won’t know unless your read my prospectus:
- If I pick the right investments and buy and sell them at the right time, you will likely earn a superior return on your investment.
- I can’t guarantee your investment returns will be above greater market returns.
- There is an upwards of 50% chance that I will underperform the s&P 500 index.
Knowing what I just told you, would you pay $1,500+ for my “I think I can beat the market” investment services?
Not All Returns are Created Equal
Consider the chart below I created using FINRA’s Fund Analyzer Tool, which shows the returns, fees and expenses for 3 randomly chosen U.S. large cap mutual funds. The first fund, the Vanguard 500 Index Fund, tracks the S&P 500 Index and is passive investment fund. The other two funds are actively managed funds from Putnam and American Funds. The fund managers for these funds are trying to “beat” the S&P 500 index returns through investment selection or “stocking picking”.
Using the tool I assumed a $10,000 initial investment, a 10-year holding period and a 5.0% annual return for each fund. Take a look at the section I highlighted, it shows that the much cheaper Vanguard fund charging only $77.09 in fees dramatically outpaces the “premium funds” that focus on stock picking. Notice that I did not use the word “outperform”, this is because the funds actually “performed” the same, earning a 5% return. Only the fees are different. In a nutshell, the two active funds spend more money to generate the same return. Correction, spend more of your money to generate the same return.
Ok, so what if an actively managed fund outperforms?
Well, based on the chart above an active manager would have generate an average return of almost 6% to give an investor the same profits as the Vanguard fund when it returns 5%. Generally speaking, this means an active manager has to outperform just to keep up with an index fund.
The reality is that active managers are paid higher fees even if they underperform the market. The below shows the 10 year performance of the two active funds above versus the S&P 500 Index. Over the 10-year period the Putnam fund generally underperformed in the first 6 years and has outperformed the index ever since, where as the American Fund has been a consistent lagger. This means investors in the American Fund likely did even worse over the past ten years than the FINRA tool could have predicted.
According to S&P’s 2011 “S&P Persistence Scorecard” very few fund managers remain consistent performers with only 9.72% of large capitalization funds maintaining a top-half ranking over 5-years. The bottom-line; it is extremely hard to beat the market consistently, so why pay a premium price for managers to “try”?
The Take-aways:
1) Fee management is SUPER important, not just for mutual funds, but also for financial advisors or wrap accounts (separate accounts). Make sure you understand the impact of fees over the long-term.
2) Professional investment managers have a very hard time consistently outperforming the markets. Don’t over-pay them to underperform, it will cost you more than simply buying the S&P 500 index tracking ETFs or mutual funds.
Do you own index funds? Are you a believer in actively managed funds or costly financial advisory services?
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Very good research and simply I’m so so impressed through this post view and hopefully I wanna share this with other. Thanks mate and keep it up.
FelixInvestments LLC
The coffee analogy lost me for a quick second, but thank you for finally explaining this in a way that I understand! The numbers speak for themselves… Why pay more to ultimately get less?!
Completely agree with this approach. It really seems like actively managed outperformance is based on luck as well as skill. Look at someone like this John Paulson. Down almost 50pc last year. Or this Bill Miller chap – something like 15 years beating the indexes, and a disaster the last 3-4 years, giving all the advantage back (and with high fees to boot!)!
I love the breakdown. I own index funds and chose them after doing some research.
As I am sure you can tell, I am a huge fan of index funds. I am only interested in paying for active management if there is a very specific expertise or the use of leverage or financial instruments that I don’t have access to. Then I would pay a higher fee to get that expertise. But not to pick large cap equities that are easily available through index funds.
I think you present a powerful argument here and I have a similar investment philosophy. Indexing is my preference for cost effective diversification, and really, I don’t think anyone can out-guess the random turns of the market over the long term. Great information!
In short… get a passive index fund or strike out on your own actively? I can get behind that…
Loving the coffee reference, Neo
I never deal with actively managed funds and would quite literally never take investment advice from a financial adviser. I have used index funds in the past and will do so again if I think the economy is not going to suck for the foreseeable future. That said, I love building a portfolio of individual securities that I’ve put time into thinking about. At least that way, even if my coffee sucks, I still have fun making it (although, my coffee has been working out pretty well for me over the last few years! 
)