Continuing on the narrative of the prior post, this post
adds the thoughts of John Bogle and Charles Ellis to the active versus passive
debate.
Fund managers aim to maximize investment returns. Over time,
markets deliver returns on their own. They’re what we call the market return.
We pay managers to deliver more than the market return. In fact, after costs,
they rarely do. John Bogle who is a sceptic of active fund management described
it as an industry built on witchcraft.
Of course, the fund management companies could justify high
fees if they added significant value. Unfortunately, the performance of
actively managed funds is consistently less than those realized by the market
as a whole.
Mr. Bogle says: “We have the most prevalent rule that
applies to fund managers everywhere, and that is reversion to the mean. A fund
that gets way ahead in the market falls way back behind it. It’s witchcraft in
the sense that it’s managers hovering over a table thinking that they have the
answer. The intellectual basis for indexing is (as I’ve said), is gross return
minus cost equals net return. Period. What is the intellectual basis for active
management? I’ve never heard one. The closest I have come is a manager saying
‘I can do better’. They all say ‘I can do better’, 100 percent of them say I
can do better than the market. But 100 percent don’t. Probably about one percent
of managers can beat the market over the very long term.”
In fact, in many cases active funds were trounced by passive
funds. For example, over ten years ended 2012, passive North American equity
funds delivered average returns of 2.6%, as opposed to 1.7% delivered by active
funds. Passive Japanese equity funds recorded average returns of 2.6%, compared
to 2.0% for active. What’s more, these returns do not take into account the
impact of fund fees.
Currently we have exceptionally talented portfolio managers who
are trying to out-compete one another in a giant negative-sum-game. Not a
zero-sum-game, but a negative-sum-game, because while they’re doing this, they
are extracting charges and fees on an annual basis which erode the capital of
investors. In this competition of trying to out-compete one another, there are
bound to be winners and losers every year, and there are some that claim that
they add value, i.e. they win more often than they lose, but if we actually
examine the data, it is nearly impossible to work out who is going to
outperform the rest on a consistent basis. For virtually all investors, making
a decision as to which active fund to invest in is like a lottery.
This underperformance is understandable. Fees are often too
high and have been rising over the past half century as skillful and diligent
investment managers using technology along with near immediate dissemination of
new information (think Reg. FD) have made the markets increasingly efficient.
Thus, most managers will be unable to absorb the costs of trading and fees and
still achieve better-than-market rates of return. Underperformance after costs
is not just understandable; it is to be expected as professional investors’
trading went from a small minority 50 years ago to an overwhelming majority
today.
The real valued added for investors is centered on
counseling—defining the appropriate long-term objectives, risk constraints,
liquidity needs, and market realities.
Gradually, however, investors have been shifting from active
performance managers to indexing. The pace may appear slow, but it has been
accelerating.
It is ironic that the skills of active managers have made it
improbable that—other than by random chance—any specific active manager will
outperform the market index for clients. Indeed, the high cost of active management
combined with its less than market average track record - and the near
impossibility of identifying the next star performer - should make the average
investor wary.
CBlakely, CFP® 10/2014
Sources:
Financial Analysts Journal July/August 2014, Volume 70 Issue 4, Rise and Fall
of Performance Investing, Charles D. Ellis, CFA. AAII Journal, June 2014, Achieving Greater
Long-Term Wealth through Index Funds
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