“[The 1990s are] strewn with examples of bright people who thought they built a better mousetrap that could consistently extract abnormal returns from the financial markets. Some succeed for a time. But while there may occasionally be misconfigurations among market prices that allow abnormal returns, they do not persist.”
Each analyst has his or her own take on the direction of interest rates, the price of gold, the outlook for the U.S. dollar and the latest technical support levels for the S&P 500.
Although I find their diverse range of opinions and insights fascinating…
I have a confession to make.
These pundits’ views have zero impact on how I invest my own hard-earned money.
And they should have no impact on how you invest yours.
Active Management in 1999
When I was a mutual fund manager 20 years ago, I spent my days reading reports and taking meetings with analysts from all of London’s major banks and brokerages.
I spent hours a day listening to highly impressive experts pitching their latest and greatest investment ideas.
Then, about four or five times a year, I got on a plane and flew to Turkey or Poland or Russia or Kazakhstan.
There, I “kicked the tires” of the companies I invested in for the emerging markets mutual funds I was managing.
I did this for two reasons.
First, I wanted to gain an “informational edge” in my personal meetings with company management.
Second, my own investors expected our team to conduct boots-on-the-ground research.
All this was part of our effort to gain an edge over other emerging markets funds investing in the same market.
Some years our funds performed better than others.
But in the end…
Because we never really swung for the fences, betting big on any single idea, our funds pretty much ended up tracking the market.
The Paradox of Active Management
If there is one eternal truth in money management, it is this…
There will always be active money managers with a hot hand who are crushing the market. And each tells a compelling tale of how their unique insight ensured their success.
Here’s the paradox…
As an investor, you never know in advance which active managers will outperform and by how much.
But once you subject the performance of active managers as a whole to careful scrutiny, you’ll find that – with very rare exceptions – they underperform their benchmark index.
1. Active managers can’t overcome the headwind of higher fees.
The average management fee of a large cap stock fund is 1%. The management fee of the Vanguard S&P 500 ETF (VOO) is 0.04%. That makes an average large cap fund 25 times more expensive than low-cost, passive index investing. Making up for that difference is tough.
2. Active managers don’t pick better stocks.
The latest data from S&P Dow Jones Indices SPIVA U.S. Scorecard is painfully clear.
Over a five-year period, the S&P 500 outperformed 80% of its active counterparts. Over a 10-year period, it outperformed 90% of them. Put another way, you can guarantee that you’ll be in the top 10% of all U.S. large cap money managers just by buying a traditional S&P 500 index fund and doing absolutely nothing.
3. Active managers can’t time the markets.
Active managers believe they can time the market – say, by moving to cash during times of market turmoil. The facts reveal otherwise. In 2008 – the worst year for stock prices in 50 years – the Vanguard 500 Index Fund still outperformed its actively managed peers.
So what should a small investor do?
Should you take the late Vanguard founder John Bogle and Warren Buffett’s “super-simple retirement advice” and just invest in an S&P 500 index fund?
While I think that’s a better option than investing in a typical large cap mutual fund with high fees…
I think there is an even better alternative.
That’s because, for small investors, there are systematic ways to “beat the market.”
And you can beat it by investing in smart beta ETFs.
These ETFs buy stocks based on time-tested factors: growth, value, momentum or even insider buying.
These strategies can help you beat the market by an average of 1% to 2% each year.
And that small difference adds up to a huge difference over time.
To add insult to injury, smart beta ETFs are far cheaper than active managers.
Here’s the bottom line: Active money management is dying a slow but inevitable death.
Traditional Vanguard index funds may have been the better and cheaper option before ETFs came on the scene.
But today smart beta ETFs – like the ones I recommend in Oxford Wealth Accelerator– offer an even better alternative.
Yes, you may get lucky and invest with an active manager who will beat the market over the next 10 years…
But I wouldn’t bet my money on it.