The Debate between Actively Managing Investments and Index-Tracking Investments

McGraw Hill Financial recently published the Year-End 2014 performance averages for actively managed mutual funds as compared to their respective benchmarks.  What isn’t a surprise is that the target those mutual funds were trying to achieve proved to be elusive for many.  What is a surprise is just how many.  Surprisingly, 80% of mutual funds on average underperformed their benchmarks over the ten-year period ending in December 2014.

I appreciate these studies because it gives me a few insights.  One is that some mutual funds managers are outperforming their benchmarks.  “But, Dan, it’s only 20% of them, roughly, on average, right?”  Yes, only 20%, but still, 20% can do it.  Plus, this study, like many, are compared against a benchmark that doesn’t have any trading costs or expenses of any kind.  I wish that instead of comparing against an expense-less benchmark, the comparison would be between the closest benchmark-tracking investment option, like the SPY instead of the S&P 500 index.  I understand that the expenses are only a fraction of a percent in most cases but understanding that there is a cost is important.  This is really my second insight – if the study included fees on ETFs or other passive investment options the outperformance would be higher.  As any good mutual fund salesman would say, “You have a nearly 100% chance of underperforming the benchmark in a benchmark-tracking ETF.”

I also have a very small gripe with reports that show one, three, five, and ten year trailing numbers.  All are affected by what I consider beginning and end point bias.  That is, if we’ve had a really good year before the time period started and ended on a bad year we’re going to have a skewed understanding of performance.  This systemic issue so it’s not a big deal.

Some market watchers think that we’re in a golden age of passive investing and that thorny issue of investing we call liquidity or the lack thereof will become an issue in the market the next time we face a significant correction.  We’ll have to see about that.  I'm not worried when it comes to domestic stocks.

As it stands I have no problem investing in ETFs that track benchmarks passively for me or my clients.  In some instances I think mutual funds provide a good opportunity as well but that opportunity set declines every year.  I have to be pretty confident the funds I choose to use either reduce risk (and so they very well may underperform their benchmark) or will be in that 20% above average over ten years.

Finally, I leave you with this I picked up from Horizon Kinetics' recent commentary.  He asks if you would sell your investment in a limited partnership that performs as such over 5 years:

Year                     Fund        S&P 500
1970                    -0.1%           2.4%
1971                      20.6%        14.9%
1972                     7.3%           19.8%
1973                    -31.9%        -14.8%
1974                    -31.5%        -26.6%
Cumulative:       -39.7%        -11.8%

Sources: and 

The catch is that the manager is Charlie Munger, the partner and financial wizard alongside Warren Buffett of the famed Berkshire Hathaway.  Not many can argue against the performance of what they have accomplished.  So yes, use ETFs and passive investments to your advantage but don’t throw the baby out of with the bathwater.

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