Active v. Passive Investing - What Works and for Whom

The next several posts will attempt to add some clarity as to which strategy may work best for different types of investors.

Its fund managers whom the vast majority of us trust with our long-term stock and bond investments. They choose which stocks and other assets to invest in on our behalf - and decide when the time is right to buy and sell. But, time and again, research has shown that we over-estimate quite how talented fund managers are and how much value they add.

For all the talk of “star” performers, the empirical evidence shows that only a tiny fraction of them outperform the market with any meaningful degree of consistency. In the UK, researchers examined 516 UK equity funds between 1998 and 2008, and found that just 1 percent of managers were able to produce sufficient returns to cover their trading and operating costs.

The remaining 99 percent of fund managers failed to deliver any outperformance - either from stock selection or from market timing (always a suckers bet).

While a tiny number of “star” managers do exist, they are incredibly hard to identify. Furthermore, the research shows it takes over 20 years of performance data to be 90 percent sure that a particular manager’s outperformance is genuinely due to skill.

According to the research, for most investors, it is simply not worth paying the vast majority of fund managers to actively manage their assets. We think we’re paying for better performance and that greater skill will produce superior results. But investing almost always works the opposite way round. The less you pay, the more you keep. Counter-intuitive, but it’s true.

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The investment industry and the media (think CNBC) tend to focus on historical fund performance. But Morningstar research shows that the most reliable indicator of long-term investment returns is in fact cost. Nobel Prize-winning economist Eugene Fama says: "If you're paying big management fees, the cumulative effect of that, given the way compounding works, is enormous."

So what sort of impact do fees and charges have on the value of our long-term investments? Well, over 40 years, your retirement fund, worth say $500,000 with no fees, would be reduced to just $349,100 with an annual charge of 1.5 percent. If overall charges reach 2.5% - and when trading costs are included, that’s not uncommon - this reduces the value of your retirement fund to less than $280,000.





So, even at 1.5 percent, almost a third of your retirement fund is lost in fees, rising to 44 percent when charges increase to 2.5 percentage points.




The message for investors is clear: keep costs as low as possible or find the one percent of funds that truly outperform over the long-term, this is crucial to a successful investment experience. With the stakes so high it makes sense to seek out the advice of a credentialed investment advisor who will look at the big picture with you.

CBlakely CFP®, CTFA           10/2014

Sources: Transcript of interview with Nobel Prize winning Professor Eugene Fama, Pensions Institute (Cass Business School) Discussion Paper PI-1404, Morningstar