I believe there are people out there who can beat the market. However, I also believe they are few and far between, and that they are essentially impossible to identify in advance. I am also a firm believer that very few of them manage mutual funds. The latest “Persistence Scorecard” published by Standard and Poors provides another chunk of evidence (as if we didn’t already have enough) that past performance is a particularly bad way to pick an actively-managed mutual fund. The summary results are worth reviewing:
Very few funds manage to consistently repeat top-half or top-quartile performance. Over the five years ending March 2011, only 0.96% of large-cap funds, 1.14% of mid-cap funds and 2.59% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
Looking at longer-term performance, 19.15% of large-cap funds with a top-quartile ranking over the five years ending March 2011 maintained a top-quartile ranking over the next five years. Only 9.38% of mid-cap funds and 23.26% of small-cap funds maintained top-quartile performance over the same period. Random expectations would suggest a rate of 25%.
While consistent top-quartile and top-half repeat rates have been at or below levels one expects based solely on chance, there is consistency in the death rate of bottom quartile funds. Across the board, fourth-quartile funds have a much higher rate of being merged and liquidated than all other funds.
The moral of the story is that you are far better off not playing a loser’s game of trying to find a mutual fund manager who can beat the market. Get the market returns at the lowest possible cost by using index funds. Eliminating the risk of underperformance is well worth giving up the slight possibility of outperformance, especially when it is likely to be very short-term.
What would you think of a doctor who didn’t consider the evidence when prescribing therapies? Why would you look at investing any differently? It has a body of evidence and peer-reviewed journals just like medicine. A physician familiar with a handful of the basic theories is likely to end up far more wealthy than one who never considers the evidence.
Hey Dr. Whitecoat.
Good advice. Check out Investor Solutions in Florida. It is based on the ideas of William Bernstein. He wrote a book called the Intelligent Investor. If I remember right he was a Dr. as well.
Correction.
The book was called The Intelligent Asset Allocator.
Thank you for your comments. Indeed, Dr. Bernstein has founded an investment management company. His books are excellent and highly recommended. All three are similar, but progressively made more clear and understandable to the reader. The first was The Intelligent Asset Allocator, and it was a bit heavy on the math. The second, 4 Pillars of Investing, was one of the first books I read on investing and really made a big difference for me. His latest, The Investor’s Manifesto , covers similar ground with updated examples. It is also shorter and easier to read. You can find links to these on my books page here:
What about low cost actively managed funds ie vanguard wellington or vanguard health care funds? I like the idea of wellington, long (80+ years) track record and automatically rebalances. But 100% agree, most of my money is in passive index funds.
Those funds are a great demonstration that what really matters is not the efficient market hypothesis, but the cost matters hypothesis. All that said, I still prefer passive. But if you can keep the costs low, active management has a much better chance.
It isn’t that managers can’t add value. It’s that they can’t add more than they cost.
Cool. Another question, probably on the wrong post. For high income investors, do you see any role for traditional bonds, or do you only invest in municipal bonds?
Sure. If your bonds are in retirement accounts, traditional bonds are probably better than munis.
i would stay away from health care funds or any sector funds. Those are the same as picking individual stocks which the academic community has shown is not good.
WCI,
Have you heard of Howard capital management 401k optimizer? I this company developed a proprietary market analysis tool that directs investors what funds to use and in what proportion. The cost is about $350/year. I am interested in your opinion on this product.
So for just $350 a year they’ll give you access to their crystal ball? Seems like a great deal!
Seriously though, if you really knew what funds to choose going forward and in what proportion you should own them, why would you waste your time selling your secrets to others for $350 a piece instead of just raking in the billions?
Very dangerous suggestions here…especially in down markets. Passive always guarantees you don’t outperform the market. Do you think people in active funds were happy to lose 25% instead of 37% utilizing active management in 2008? Perhaps just mentioning investors should be cognizant of fees makes more sense.
Your comment suggests a misconception- that actively managed mutual funds somehow help you avoid market down turns. The evidence suggests this is not the case. Larry Swedroe makes the case rather convincingly for me here:
http://www.cbsnews.com/news/active-fund-managers-bear-market-myth/
One advantage an active fund may have in a bear market, of course, is that they tend to hold more cash in all markets. So naturally that makes for a less aggressive asset allocation which theoretically should do better when markets are going down. Unfortunately, it doesn’t seem to make enough of a difference, plus it retards your growth when markets are going up, which is 2/3 of the time.
As a reader of this website for several years I’m not impressed by your response including a link from a news article dated 2009. I hope there is better evidence than a 2009 article written by Larry Swedroe to support the idea for everyone to “avoid actively managed funds”. Please read an article Larry authored in March 2015 regarding his review of the Fidelity Contrafund – Fidelity’s largest actively managed fund. He goes in depth to review the fund and show it’s out- performance against an index. We are all conflicted on this topic..myself included. That is why the debate rages on! The most important thing here is to provide people with unbiased and accurate information to make decisions for themselves. Telling everyone to avoid active funds is not only inaccurate but also misleading. I would have rather seen a commandment titled, “Thou Shalt Carefully Utilize The Proper Low Cost Asset Allocation”. I’ve never written a comment on a web page prior to this one. I felt strongly to do so this time since I respect what this website does for many physicians young and old. However, we all need to be careful to make sure the hard work is done to provide accurate information to empower your audience to make smart choices with their money. I’m sure you will take exception with my comment but I will provide no further response. All the best and time to get back to work!
I disagree that the debate rages on. But like I tell the whole life guys, if you save enough you can invest in anything you want. If you love actively managed mutual funds and think they’re the best thing since sliced bread, buy as much of them as you like.
But when the secret to finding a good actively managed mutual fund is to find one that looks as much like a low-cost Vanguard index fund as possible, you’ve got to wonder why not just buy the low-cost Vanguard index fund and not run an additional risk (manager risk?)
Here’s the link you mention from Swedroe: http://www.valuewalk.com/2015/03/fidelity-contrafund/
It seems like you didn’t read all the way to the end of the article. Here’s the end:
Finding a fund through your retrospectoscope that beat an index isn’t hard. The hard part is finding one going forward. It turns out that’s not a game worth playing.
Advising readers to avoid actively managed mutual funds as a general rule is neither new for this site, nor bad advice. But there are many raods to Dublin.
And if you’re really looking for better evidence, I’d suggest any book by Swedroe, Ferri, Bernstein, or Bogle.
Here’s another article on the site: https://www.whitecoatinvestor.com/people-still-believe-in-active-management/
The main reason passive works is indeed lower costs, but that’s not the only reason. However, if you ARE going to try to pick an actively managed fund, starting with a low cost one seems to be the best strategy.
I am actually surprised there aren’t MORE articles written about active management, as so many people in the financial world benefit from raking in money from high management fees. And the articles that are written, are often very biased (they want popular opinion to sway heavily towards active management, otherwise they are out of their lucrative profession). I am still trying to convince my parents to leave HIGH fee actively-managed funds that have consistently underperformed the market when you take into account the expense ratios. The S&P 500, even, would have put them in a much better spot and with the ability to retire earlier. Both are in their sixties and planning to work until at least 70, if not longer, health permitting. Moral of the story – be careful with actively managed funds, those fees add up over time and will come back to haunt you with either late retirement, or a less comfortable one!
Before I found your website and started reading some of the finance related books I invested part of my savings in a taxable account into Fidelity ContraFund (FCNTX). Now that I have read multiple sources that recommend keeping costs down I am not sure what to do with the 2.8% of my portfolio that is invested in FCNTX. I compared it with Vanguards and Fidelity’s Whole Market funds (VTSAX and FSTVX) and it has consistently outperforms those funds. I know the turnover and net EXP are high for this fund but still can’t find any concrete reason besides the mantra “Always keep costs down” to transfer money to a low cost index fund. Any advice?
Contrafund is a large growth fund so it is best compared to another large growth fund rather than a total market fund. Vanguard’s Growth Index fund is a reasonable comparison, although it isn’t quite as large or as growthy. They are fairly comparable return wise at least for the last decade (although Fidelity had a very good 5 year period in comparison about 15 years ago.)
YTD
Fid -5.2%
VG – -4.11%
5 year
Fid 11.05%
VG 11.72%
10 year
Fid 7.95%
VG 7.80%
15 year
Fid 8.11%
VG 5.79%
At any rate, the point is that an index fund is not guaranteed to beat any actively managed fund over any given time period, even a very long one. But the odds that it will do so are quite good. But there is likely to be at least a few funds that beat an appropriate index. Over the last 15 years, Contrafund is one of those, which is part of the reason for its fame and size. Of course, there is also no guarantee that Contrafund will continue to outperform going forward just because it has in the past. For example, over the last 5 years and YTD it has underperformed. So you makes your bets and you takes your chances. In a taxable account, you have an even bigger issue because you likely are faced with a significant capital gains tax for switching, making switching even less attractive. So while you might put new money into an index fund, you might keep the old money in an actively managed fund with low basis.
Hope that helps.