Benefits For All?
In the short term, manager skill or luck (we won't get into it here) will be the most important factor that will
put you ahead or behind.
But in the long-term, the ups and downs in performance, created by the manager
going into and out of his/her stock picks, will even out. The slow but
continuous drain on your capital, from fund fees and portfolio transaction
costs, will overtake the gains you made when the manager had some good
years.
Mutual
fund companies know this, but hide the information extraordinarily well because it's not in their best interest, as a
profit-seeking business, to focus on it. Many fund company employees themselves,
don't understand the statistical analysis that prove there is no long-term benefit to active management.
(Here's just one recent study:
2008 Study
)
The statistics are difficult. However, if
you believe it's impossible to predict the weather next year, then their conclusions should come as no surprise.
Why are so many people wasting their money in bad funds? Greed and fear.
Psychology trumps statistical facts. You may not be greedy on the level of a
Gordon Gekko, but your desire to do better than your friends and family is greater
than you want to admit. Fear? We fear doing anything that is
away from the herd. Investing in passive fund, despite the success of
Vanguard, for example, is still a scary proposition to people who believe the
market's ups and down can be foretold.
The bottom line is that you will always feel pressure to "do something" with
your investments. There will always be some funds that, for whatever reason, will end up beating most passive funds (you won't hear about the majority that don't).
Unless you invest in a passively-managed index fund, when your fund wins, a
neighbor loses. When a neighbor wins, you lose.
The fund company always makes
money. Have you ever noticed that no established mutual fund company has EVER gone out of business? Their longevity is due to
your inertia (few people move their investment from one fund family to another) and their rich profits which allow
them to weather the lean years in comfort.
Fund managers do not deliver
benefits for all.
Their closest equivalents are poker players. They compete for a larger share of
the market at the expense of someone else. True, when the market rises
they can benefit, but so does everyone else.
Most people who sell funds gloss over zero-sum math. Some go so far
as to try to convince you that money managers "make" money. They compare
their skill to that of a good doctor or lawyer. It is a faulty comparison.
Let's compare a fund manager to a doctor. If you broke your arm you'd try to hire
an expensive orthopedic doctor who heals 80 out of 100 broken arms, rather than a cheaper one who heals
8 out of 100. But you wouldn't be surprised if, a year later, a technical advance allowed
ALL doctors, even cheap ones, to heal 100 out of 100 bones. It's a mathematical certainty that no fund manager will
make everyone rich.
Medical science creates improvements for all. When a doctor fixes your arm someone else doesn't end up with
a broken arm, as is what happens in the stock market.
A fund manager chooses from a securities pie in which every investor shares. Some securities do well,
others poorly. Fund managers cannot create improvements
for all. They can only get you a slice of pie that hopefully widens at the expense of another.
It's a zero-sum game. The fund winners minus the fund loser equals zero
(actually less if you count fund fees).
If fund managers were doctors, everytime one patient got well another would die.
Why isn't this apparent to all? Time and Variation. It takes decades for the effect of fees to
sink below the short term waves of performance. Fund companies close or merge
the funds that make that obvious. Then they push the funds that are doing well. It distorts the
public's perception. By the time most investors realize they would have saved more in a low-fee fund
(or bought securities directly) it's
too late. They've already been shuffled around a few funds and have transferred much of their wealth to the fund
management company.
If you gathered everyone into a room who said 'I don't care about anyone else,
my fund will win' you would discover, as hundreds of PhDs studying the problem
before you, that you have grossly underestimated the number of real losers.
Then why don't managers promise to
deliver a certain return or they don't get paid? They don't for the same reason
casinos don't promise that everyone will win. Everyone doesn't. No manager is
foolish enough to promise the impossible. They're in business to make
money on your desire. A greedy or fearful investor is their best customer.
Of course, most fund managers don't think you're greedy or fearful. They
don't think about you at all. They're enjoying the thrill of trying to
beat the market. It's a great job. They're betting your money, not theirs.
This is a good reason. Investing passively just feels wrong.
If every fund were put into a giant no-fee index fund, every company would look to go public. Once they
were public they could rely on the index funds to hold their stocks through thick and thin.
Through stock selection, fund managers weed out bad companies and help good companies, because through higher
stock prices, they can raise more capital.
Granted, most people who pay for active management don't do better than index funds.
But they create a competitive atmosphere which is good for everyone.
Such arguments are muted by the fact that active investors buy stock individually and create enough
competition in the market.
One could even argue, all the investors of high fee funds unwittingly make more
money for low-cost investors.
Low-fee investors end up with higher returns because they enjoy the fruits of
competitive weeding-out that they didn't have to pay for. Instead of trying to make money in the
casino, they buy the casino itself. Over time the casino will do better than most winners
because most winners pay too much to gamble.
Let's assume there are fund managers who can 'beat' the market. What
gives you the expertise to pick them? Without that expertise how can you possibly pick
the picker, who picks the stocks that beat the other pickers?