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Why Most Active Fund Management Often Underperforms, Ep 6

Why Active Fund Management Often Underperforms
Do more with what you’ve earned.

Financial advisors for successful professionals, executives, and business owners.

Some of the most famous investment advisors out there are involved in Active Fund Management – big name people like Warren Buffett and George Soros. They are famous because they are so successful at actively managing investment funds, regularly beating the averages reflected in the S&P 500, for example. But most active fund management is not that successful – not even close.

On this episode, I want to help you understand the difference between active and passive management funds and why the Warren Buffets of the world can perform so incredibly well – and why your manager likely won’t be able to do so.

Outline of This Episode

  • [1:23] Our team’s recent move to La Hoya – why and what it’s done for us
  • [2:41] What is an ACTIVE fund (as opposed to a passive fund)
  • [3:41] How many funds actually underperform their benchmark?
  • [5:52] An illustration to explain how news travels faster than managers can handle
  • [10:35] Is it impossible to find a manager who can beat the benchmarks?
  • [13:35] The best course of action for those who are not in the know

The difference between active and passive fund management

Before we can talk about the reasons active fund managers usually underperform, it’s important to understand first what an active fund is. An active fund is a public or private investment fund where the manager is actively trying to outperform a particular benchmark with his/her investment decisions. Some examples of these benchmarks are the S&P 500, the Russell 2000, and Barclay’s Aggregate Bond Index. There are literally thousands of these indexes that make up the entire market.

A passive fund, on the other hand, is not actively managed in an attempt to beat those benchmarks. Passive funds simply want to mimic or match what the benchmark indexes are doing, so they are much less hands-on in terms of management. This keeps fees low and allows the manager to take a simple investing approach. Interestingly, this approach does typically outperform active fund approaches.

What percentage of active funds underperform?

When you hear the difference between an intentional, active management approach and a passive fund approach, it seems unbelievable that active management is the lesser performer of the two. But it is – by a very wide margin.

Over the past 5 years, 82% of actively managed funds have underperformed their benchmark. That represents an abysmal failure of the active management model, in my book. I think there are much better ways to ensure better returns than active fund management.

What is driving the underperformance of today’s active fund managers?

The reason actively managed funds perform so poorly has to do with what is called information diffusion. To put it simply, it has to do with the rate at which information spreads throughout the marketplace. Given that we use modern technologies commonly in the stock and investment world, information travels faster all the time, which means it becomes more and more difficult for managers to meet benchmarks because the information that would enable them to make good investment choices travels faster than they can keep up with. In actuality, there is an extremely short window within which to capitalize on news that would impact investment decisions.

By comparison, in the mid-80s this was not the case because much more effort and time were required to get the news out about happenings that would impact stock pricing. In those days, fund managers could more easily and readily capitalize on news as needed to bring value (Alpha) to their investors.

What can the average manager do to provide value? Buy passive funds

If you’re hoping to find the next Warren Buffet to actively manage your investments, it’s not likely you’re going to find that person. New managers may be able to show the proof of having a fabulous year here and there, but without a long term track record to look at, It’s difficult to separate skill from luck. Newer managers don’t usually have access to the high-level connections that make it possible to outperform the indexes. There is clearly a relationship between successful brokers and institutional investors that enables the brokers to leak the info to their select clients who can then take advantage of the news.

Instead of taking that approach at all, I recommend fund managers follow passive fund strategies that have proven to outperform active approaches to fund management and to focus on the things that can be controlled on a personal level. Those things would be getting personal budgets in line, saving as much as you can, and planning accordingly.

If you find this episode helpful, I’d love to hear about your experience. Please contact me using the contact info at the bottom of the page.

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